Strategic
Management
Strategy
Strategy is a long-term plan formulated by the top-level
management to match/fit the internal environment of an organization with
external environment.
Alfred Chandler defined strategy as “the determination of the
basic long-term goals and objectives of an enterprise, and the adoption of
courses of action and the allocation of resources necessary for carrying out
these goals.”
A Model of the Strategic
Management Process
The strategic management process can be broken down into five
different components. The five components are (1) selection of the corporate
mission and major corporate goals; (2) analysis of the organization’s external
competitive environment to identify opportunities and threats; (3) analysis of
the organization’s internal operating environment to identify the
organization’s strengths and weaknesses; (4) the selection of strategies that
build on the organization’s strengths and correct its weaknesses in order to
take advantage of external opportunities and counter external threats; and (5)
strategy implementation.
Components of the Strategic
Management Process:
Defining the Mission
The first component of the strategic management process is
defining the mission and major goals of the organization. The mission and major
goals of an organization provide the context within which intended strategies
are formulated and the criteria against which emergent strategies are
evaluated.
External Analysis: The second component of the strategic management process is the
analysis of the organization’s external operating environment. The objective of
external analysis is to identify strategic opportunities and threats in the
organization’s operating environment. Three interrelated environments should be
examined at this stage: the immediate, or industry environment in which the
organization operates, the national environment, and the wider macro
environment.
Internal Analysis: Internal analysis, the third component of the strategic management
process, serves to pinpoint the strengths and weaknesses of the organization.
Such analysis involves identifying the quantity and quality of resources
available to the organization. Building and maintaining a competitive advantage
requires a company to achieve superior efficiency, quality, innovation, and
customer responsiveness. Company strengths lead to superiority in these areas,
whereas company weaknesses translate into inferior performance.
Strategic Choice: The next component involves generating a series of strategic
alternatives, given the company’s internal strengths and weaknesses and its
external opportunities and threats. The comparison of strengths, weaknesses,
opportunities, and threats is normally referred to as a SWOT analysis. The
purpose of the strategic alternatives generated by a SWOT analysis should be to
build on company strengths in order to exploit opportunities and counter
threats and to correct company weaknesses.
Strategy Implementation: Strategy implementation, the fifth component of the strategic
management process, consists of four components: (1) designing appropriate
organizational structures, (2) designing control systems, (3) marching
strategy, structure, and controls, and (4) managing conflict, politics, and
change.
Reasons
for Fit Model’s Failure (Non-Psychological Factors)
Five explanations can be offered as to why formal strategic
planning systems based on the fit model do not produce better results. We
consider four of them as the non-psychological factors. The four explanations
are as follows: (1) planning equilibrium, (2) planning under uncertainty, (3)
ivory tower planning, and (4) strategic intent versus strategic fit.
Planning Equilibrium: For a valuable management technique such as formal planning to be
a source of competitive advantage, some companies must have the technique while
others do not. In such circumstances, we might expect those with the technique
to outperform those lacking it. However, once everybody has the technique, it
levels the playing field. A technique used by every company can no longer be a
source of competitive advantage. In such a situation, we say that the technique
is in equilibrium. Because almost all large companies currently have some kind
of formal strategic planning process, a condition of planning equilibrium
exists. Thus planning may be necessary to earn average profits, but it will not
by itself allow a company to earn the above-average profits associated with
competitive advantage.
Planning Under Uncertainty: Executives often assumed that it was
possible to forecast the future accurately. But in the real world, the only
constant is change. Even the best-laid plans can fall apart if unforeseen
contingencies occur. The recognition that in an uncertain world the future
cannot be forecast with sufficient accuracy led to the scenario approach to
planning. Rather than try to forecast the future planners attempt to model the
company’s environment and then use that model to predict a range of possible
scenarios. Executives are then asked to devise strategies to cope with the
different scenarios. The objective is to get managers to understand the dynamic
and complex nature of their environment and to think through problems in a
strategic fashion.
Ivory Tower Planning: A serious mistake made by many companies in their initial
enthusiasm for planning has been to treat planning as an exclusively top
management function. This ivory tower approach can result in strategic plans
formulated in a vacuum by planning executives who have little understudying or
appreciation of operating realities. As a consequence, they formulate
strategies that do more harm than good. The ivory tower concept of planning can
also lead to tensions between planners and operating personnel.
Correcting the ivory tower approach to planning involves
recognition that, to succeed, strategic planning must comprise managers at all
levels of the corporation. It is important to understand that much of the best
planning can and should be done by operating managers. They are the ones
closest to the facts. The role of corporate-level planners should be that of
facilitators, who help operating managers do the planning.
Strategic Intent versus Strategic Fit: The strategic fit
model of planning has been criticized by C. K. Prahalad of the University of Michigan
and Gary Hamel of London
Business School
The secret of the success of companies like Toyota
They argue that strategic intent also encompasses an active
management process, which includes: “focusing the organization’s attention on
the essence of winning; motivating people by communicating the value of the
target; leaving room for individual and team contributions; sustaining
enthusiasm by providing new operational definitions as circumstances change;
and using intent consismndy to guide resource allocations.”
Thus underlying the concept of strategic intent is the notion that
strategy formularion should involve setting ambitious goals, which stretch a
company, and then finding ways to build the resources and capabilities
necessary to attain those goals.
Reasons
for Fit Model’s Failure (Psychological Factors)
Many managers are poor strategic decision makers. The reasons have
to do with two related psychological phenomena: cognitive biases and
groupthink.
Cognitive Biases: The rationality of human decision makers is bounded by our own
cognitive capabilities. We are not supercomputers, and it is difficult for us
to absorb and process large amounts of information effectively. As a result, we
tend to fall back on certain rules of thumb, or heuristics, when making
decisions. Many of these rules of thumb are actually quite useful, since they
help us to make sense out of a complex and uncertain world. However, sometimes
they also lead to severe and systematic errors in the decision making process.
(Systematic errors are errors that appear time and time again). These
systematic errors seem to arise from a series of cognitive biases in the way
that human decision makers process information and reach decisions- Because of
cognitive biases, many managers end up making poor strategic decisions.
The prior hypothesis bias refers to the fact that decision
makers who have strong prior beliefs about the relationship between two
variables and to make decisions on the basis of these beliefs, even when
presented with evidence that their beliefs are wrong. Moreover, they tend to
seek and use information that is consistent with their prior beliefs, while
ignoring information that contradicts these beliefs. To put this bias in a
strategic context, it suggests that a CEO who has a strong prior belief that a
certain strategy makes sense might continue to pursue that strategy, despite
evidence that it is inappropriate or failing.
Another well-known cognitive bias is referred to as escalating
commitment. Escalating commitment occurs when decision makers, having
already committed significant resources to a project, commit even more
resources if they receive feedback that the project is failing. This may be an
irrational response; a more logical response would be to abandon the project
and move on, (that is, to “cut your losses and run”), rather than escalate
commitment. Feelings of personal responsibility for a project apparently induce
decision makers to stick with a project, despite evidence that it is failing.
The bias of reasoning by analogy involves the use of simple
analogies to make sense out of complex problems. For example, several companies
have relied on the analogy of a three-legged stool to justify diversifying into
business areas of which they had little prior knowledge. The analogy suggests
that a stool with fewer than three legs— and by extension, a company that is
active in fewer than three different businesses— is unbalanced.
Representativeness is a bias rooted in the tendency to generalize from a small
sample, or even a single vivid anecdote. Generalizing from small samples,
however, violates the statistical law of large numbers, which says that it is
inappropriate to generalize from a small sample, let alone from a single case.
The final cognitive bias is referred to as the illusion of
control. Illusion of control is the tendency to overestimate one’s ability to
control events. Top-level managers seem to be particularly prone to this bias.
Having risen to the top of an organization, they tend to be overconfident about
their ability to succeed. Senior managers are typically overconfident about
their abilities to create value by acquiring another company. Hence, they end
up making poor acquisition decisions, often paying far too much for the
companies they acquire. Subsequently, servicing the debt taken on to finance
such an acquisition makes it all but impossible to make money from the
acquisition.
Groupthink: The biases just discussed are individual biases. However, most
strategic decisions are made by groups, not individuals. Thus the group context
within which decisions are made is clearly an important variable in determining
whether cognitive biases will operate to adversely affect the strategic
decision-making processes. The psychologist Irvin Janis has argued that many
groups are characterized by a process known as groupthink and that as a result
many groups do make poor strategic decisions. Groupthink occurs when a group of
decision makers embarks on a course of action without questioning underlying
assumptions. Typically, a group coalesces around a person or policy. It ignores
or filters out information that can be used to question the policy, and develops
after-the-fact rationalizations for its decision. Thus commitment is based on
an emotional rather than an objective, assessment of the correct course of
action. The consequences can be poor decisions. Groupthink-dominated groups are
characterized by strong pressures toward uniformity, which make their members
avoid raising controversial issues questioning weak arguments, or calling a
halt to softheaded thinking.
Techniques
for Improving Decision Making
The existence of cognitive biases and groupthink raises the issue
of how to bring critical information to bear on the decision mechanism so that
strategic decisions made by the company are realistic and based on thorough
evaluation. Two techniques known to counteract groupthink and cognitive biases
are devil’s advocacy and dialectic inquiry. Devil’s advocacy and dialectic
inquiry, have been proposed as two means of guarding against the weaknesses of
the expert approach.
Devil’s advocacy involves the generation of both a plan and a
critical analysis of the plan. One member of the decision-making group acts as
the devil’s advocate, bringing out all the reasons that might make the proposal
unacceptable. In this way, decision makers can become aware of the possible
perils of recommended courses of action.
Dialectic inquiry is more complex, for it involves the generation
of a plan (a thesis) and a counterplan (antithesis). The plan and the
counterplan should reflect reasonable but conflicting courses of action.
Corporate decision makers consider a debate between advocates of the plan and
counterplan. The purpose of the debate is to reveal problems with definitions,
recommended courses of action, and assumptions. As a result, corporate decision
makers and planners are able to form a new and more encompassing conceptua1ization
of the problem, which becomes the final plan (a synthesis).
The corporate mission statement is the first key indicator of how
an organization views the claims of its stakeholders. Its purpose is to set the
organizational context within which strategic decisions will be made— in other
words, to give an organization strategic focus and direction. All strategic
decisions flow from the mission statement. Typically, the mission statement
defines the organization’s business, stares its vision and goals, and
articulates its main philosophical values. In examining how organizations
formulate such statements, we concentrate on these three main components. Vision
and Major Goals
The second component of a company’s mission statement, the
detailing of its vision and major corporate goals, is a formal declaration of
what the company is trying to achieve. The spelling out of the vision and major
goals gives direction to the corporate mission statement and helps guide the formulation
of strategy.
Strategic Intent, Vision, and Goals
“Strategic intent” refers to the intention of a business to
coordinate and drive the whole of the organization towards predetermined sets
of goals or objectives. Strategic intent gives a notion that managers should
set ambitious goals that stretch a company. Often, the vision presented in a
company’s mission statement articulates the company’s strategic intent. Thus,
Weyerhaeuser’s vision, proclaimed in its mission statement, is to be “the best forest
products company in thee world”. This is Weyerhaeuser's strategic intent. -
Another example, the mission statement of Philip Morris Companies, Inc. This
company’s vision, or its strategic intent, is to be “the most successful
consumer packaged goods company in the world”. Both Philip Morris and
Weyerhaeuser have adopted ambitious visions, which are likely to stretch their
respective organizations.
Beyond articulating their vision, many companies also stare other
major goals in their mission statement. These goals specify how a company
intends to go about attaining its strategic intent. So, for example,
Weyerhaeuser mission statement tells the company that it intends to attain its
vision by focusing on total quality, empowering its employees, and striving to
satisfy customers. The Philip Morris statement makes plain the company’s intent
to achieve its vision by maximizing productivity and synergy and stressing
total quality management. Both companies list other specific goals. All these
goals shape the choice of strategies. The goal of maximizing productivity, for
instance, indicates that when Philip Morris reviews its strategic options, it
will favor strategies that increase its productivity.
Maximizing Stockholder Wealth
Although most profit-seeking organizations operate with a variety
of major corporate goals, within a public corporation all these goals should be
directed toward one end: maximizing stockholder wealth. Stockholders provide a
company with capital and in exchange expect an appropriate return on their
investment. A company’s stockholders are its legal owners. Consequently, the
overriding goal of most corporations is to maximize stockholder wealth, which
involves increasing the long-run return earned by stockholders from owning
shares in the corporation.
Stockholders receive returns in two ways: from dividend payments
and from capital appreciation in the market value of a share (that is, by
increases in stock market prices). A company can best maximize stockholder
returns by pursuing strategies that maximize its own return on investment
(ROI), which is a good general indicator of a company’s efficiency. The more
efficient a company is, the better its future prospects look to stockholders
and the greater is its ability to pay dividends. Furthermore, higher ROI leads
to greater demand for a company’s shares. Demand bids up the share price and
leads to capital appreciation.
The Short-Term Problem
As management theorist Peter F. Drucker and many others have
pointed out, there is danger in emphasizing only ROI. An overzealous pursuit of
ROI can misdirect managerial attention and encourage some of the worst
management practices, such as maximizing short-run rather than long-run ROI. A
short-run orientation favors such action as cutting expenditures judged to be
nonessential in that span of time— for instance, expenditures for research and
development, marketing, and new capital investments. Although decreasing
current expenditure increases current ROI the resulting underinvestment, lack
of innovation, and poor market awareness jeopardize long-run ROI. Yet despite
these negative consequences, managers do make such decisions because the
adverse effects of a short-run orientation may not materialize and become
apparent to stockholders for several years. By that time the management team
responsible may have moved on, leaving others to pick up the pieces.
In a now famous Harvard Business Review article, Robert H. Hayes
and William J. Abernathy argue that the widespread focus on short-runt ROI has
been a major factor for the long-run loss of international competitiveness by U.S.
Secondary Goals
To guard against short-run behavior, Drucker suggests that
companies adopt a number of secondary goals in addition to ROI. These goals
should be designed to balance short-run and long-run considerations. Drucker's
list includes secondary goals relating to these areas: (1) market share, (2)
innovation, (3) productivity, (4) physical and financial resources, (5) manager
performance and development. (6) worker performance and attitude, and (7)
social responsibly. Although such secondary goals need not be part of a mission
statement, many of the most important ones are. Even if a company does not
recognize secondary goals explicitly, it must recognize them implicitly through
a commitment to long-run profitability.
Corporate
Philosophy
The third component of a mission statement is a summing up of the
corporate philosophy: the basic beliefs, values, aspirations, and philosophical
priorities that the strategic decision makers are committed to and that guide
their management of the company. It tells how the company intends to do
business and often reflects the company’s recognition of its social and ethical
responsibility. Thus a statement of cooperate philosophy can have an important
impact on the way a company conducts itself.
Many companies establish a philosophical creed to emphasize their
own distinctive outlook on business. A company’s creed forms the basis for
establishing its corporate culture. The credo Johnson & Johnson expresses
Johnson & Johnson’s belief that the company’s first responsibility is to
the doctors, nurses, and patients who use J&J products. Next come its
employees, the communities in which these employees live and work, and finally
the stockholders. The credo is prominently displayed in every manager’s office;
and according to the Johnson & Johnson managers, the credo guides all
important decisions.
Corporate Stakeholders Stakeholders and The Mission
Statement
Stakeholders are individuals or groups that have some claim on the
company. They can be divided into internal claimants and external claimants.
Internal claimants are stockholders and employees, including executive officers
and board members. External claimants are all other individuals and groups
affected by the company’s actions. Typically, they comprise customers,
suppliers, governments, unions, competitors, local communities and the general
pubic.
All stakeholders can justifiably expect that the company will
attempt to satisfy their particular demands. Stockholders provide the
enterprise with capital and in exchange expect an appropriate return on their
investment. Employees provide labor and skills and in exchange expect
commensurate income and job satisfaction. Customers want value for money.
Suppliers seek dependable buyers. Governments insist on adherence to
legislative regulations. Unions demand benefits for their members in proportion
to their contributions to the company. Rivals seek fair competition. Local
communities want companies that are responsible citizens. The general public
seeks some assurance that the quality of life will be improved as a result of
the company’s existence.
A company has to take these claims into account when formulating
its strategies, or else stakeholders may withdraw their support. Stockholders
may sell their shares, employees leave their jobs, and customers buy elsewhere.
Suppliers are likely to seek more dependable buyers, whereas governments can
prosecute the company. Unions may engage in disruptive labor disputes, and
rivals may respond to unfair competition. Communities may oppose the company’s
attempts to locate its facilities in their area, and the general public may
form pressure groups, demanding action against companies that impair the quality
of life. Any of these reactions can have a disastrous impact on an enterprise.
A mission statement enables a company to incorporate stakeholder
claims into its strategic decision making and thereby reduce the risk of losing
stakeholder support. The mission statement thus becomes the company’s formal
commitment to a stakeholder group; it carries the message that strategies will
be formulated with the claims of those stakeholders in mind. Any strategies
that the company generates should reflect its major corporate goal, i.e.,
shareholder wealth maximization. Similarly, the mission statement should
recognize additional stakeholders claims in its secondary goals and philosophy.
Stakeholder Impact Analysis
A company cannot always satisfy the claims of all stakeholders.
The claims of different groups may conflict, and in practice few organizations
have the resources to manage all stakeholders. For example, union claims for
higher wages can conflict with consumer demands for reasonable price and
stockholder demands for acceptable returns. Often the company must make
choices. To do so, it must identify the most important stakeholders and give
highest priority to pursuing strategies that satisfy their needs. Stakeholder
impact analysis can provide such identification. Typically, stakeholder impact
analysis involves the following steps:
1.
Identifying stakeholders
2.
Identifying stakeholders’ interests and concerns
3.
As a result, identifying what claims stakeholders are likely to
make on the organization
4.
Identifying the stakeholders that are most important from the
organization’s perspective
5.
Identifying the resulting strategic challenges.
Such an analysis enables the company to identify the stakeholders
most critical to its survival and allows it to incorporate their claim into the
mission statement explicitly. From the mission statement, stakeholder claims
then feed down into the rest of the strategy formulation process. For example,
if community involvement is identified as a critical stakeholder claim, it must
be incorporated in the mission statement, and any strategies that conflict with
it must be rejected.
Mechanisms
to Hold in Check the Empire
Building
There is a need for mechanisms that allow stockholders to remove
incompetent or ineffective managers. A number of governance mechanisms perform
this function, including stockholder meetings, the board of directors,
stock-based compensation schemes, the takeover market, and leveraged buyouts.
Stockholders Meeting
The constitution of most publicly held corporations specifies that
companies should hold stockholder meetings at least once a year. These meetings
provide a forum in which stockholders can voice their approval or discontent
with management. In theory, at such meetings stockholders can propose
resolutions that, if they receive a majority of stockholder votes, can shape
management policy, limit the strategies management can pursue, and remove and
appoint key personnel. In practice, though, until quite recently stockholder
meetings functioned as little more than rubber stamps for management
resolutions. Stockholders must finance their own challenges and, in many cases,
meet stiff regulations limiting the number of proxy votes they can solicit.
Thus proposing resolutions critical of management was normally deemed too
expensive and difficult to be worthwhile. Rather; it was understood that
stockholders could best show dissatisfaction with a company by selling their
shares.
The Role of Board
Stockholder interests are looked after within the company by the
board of directors. Board members are directly elected by stockholders, and
under corporate law the board represents the stockholders’ interests in the
company. Thus the board can be held legally accountable for the company’s
actions. Its position at the apex of decision making within the company allows
the board to monitor corporate strategy decisions and ensure that they are
consistent with stockholder interests. If the board’s sense is that corporate
strategies are not in best interest of stockholders, it can apply sanctions
such as voting against management nominations to the board of directors or
submitting their own nominees. In addition, the board has the legal authority
to hire, fire, and compensate corporate employees, including, most importantly,
the CEO.
The typical board comprises a mix of insiders and outsiders.
Inside directors are required because they have valuable information about the
company’s activities. Without such information the board cannot adequately
perform its monitoring function. But since insiders are full-time employees of
the company, their interests tend to be aligned with those of management.
Hence, outside directors are needed to bring objectivity to the monitoring and
evaluation processes. Outside directors are not full-time employees of the
company. Many of then are full-time professional directors who hold positions
on the boards of several companies. The need to maintain a reputation as
competent out-side directors gives them an incentive to perform their tasks as
objectively and effectively as possible.
Stock-Based Compensation Schemes
To get around the problem of captive boards, stockholders have
urged many companies to introduce stock-based compensation schemes for their
senior executives. These schemes are designed to align the interests of mangers
with those of stockholders. In addition to their regular salary, senior
executives are given stock options in the firm. Stock options give managers the
right to buy the company’s shares at a predetermined price, which may often
turn out to be less than the market price of the stock. The idea behind stock
options is to motivate managers to adopt strategies that increase the share
price of the company, for in doing so they will also increase the value of their
stock.
The Takeover Constraint and Corporate Raiders
If the board is loyal to management rather than to stockholders or
if the company has not adopted stock-based compensation schemes, then, as
suggested earlier, management may pursue strategies and take actions
inconsistent with maximizing stockholder wealth. Stockholders, however, still
have some residual power, for they can always sell their shares. If they start
doing so in large numbers, the price of the company’s share will decline. If
the share price falls far enough, the company might be worth less on the stock
market than the book value of its assets, at which point it may become a
takeover target.
The risk of being bought out is known as the takeover constraint.
The takeover constraint effectively limits the extent to which managers can
pursue strategies and take actions that put their own interests above those of
stockholders. If they ignore stockholder interests and the company is bought
out, senior managers typically lose their independence and probably their jobs
as well. So the threat of takeover can constraint management action.
Corporate
raiders are individuals or institutions that buy up large blocks of shares in
companies that they think are pursuing strategies inconsistent with maximizing
stockholder wealth. They argue that if these companies pursued different
strategies, they could create more wealth for stockholders. Raiders buy stock
in a company either to take over the business and run it more efficiently or to
bring on a change in the top management, replacing the existing team with one
more likely to maximize stockholder welfare.
Poison Pills and Golden Parachute
One response by management to the threat posed by takeovers has
been to create so-called poison pills. The purpose of a poison pill is to make
it difficult for a raider to acquire a company. Another response to the threat
posed by takeovers has been the increasing use of golden parachute
contracts. Golden parachutes are severance contracts that handsomely
compensate top-level managers for the loss of their jobs, in the event of a
takeover. These contracts came into being because of fears that takeover
threats were forcing managers to focus on maximizing short-term earnings in an
attempt to boost the company’s current stock price, thereby reducing the risk
of takeover at the expense of long-run investments in R&D and new capital
equipment. Managers also complained that the threat of takeover diminished
their willingness to fund risky but potentially profitable investments. Advocates
of golden parachute contracts argue that by reducing managers’ concerns about
losing their jobs, the contracts encourage managers to focus on long-run
investment and take necessary risks. In addition, because they lessen worry
about job loss, golden parachute contracts make it more likely that top
management will review takeover proposals objectively, taking stockholder
interests into account when deciding how to respond.
Leveraged Buyouts
The leveraged buyout (LBO) is a special kind of takeover. Whereas
in a typical takeover a raider buys enough stock to gain control of a company,
in an LBO a company’s own executives are often (but not always) among the
buyers. The management group undertaking an LBO typically raises cash by
issuing bonds and then uses that cash to buy the company’s stock. Thus LBOs
involve a swap of equity for debt. In effect the company replaces its
stockholders with creditors (bondholders), transforming the corporation from a
public into a private entity. However, often the same institutions that were
major stockholders before an LBO are major bondholders afterward. The
difference is that as stockholders they were not guaranteed a regular dividend
payment from the company; as bondholders they do have such a guarantee.
Shaping
the Ethical Climate of an Organization
To foster awareness that strategic decisions have an ethical
dimension, a company must establish a climate that emphasizes the importance of
ethics. This requires at least three steps. First, top managers have to use their
leadership position to incorporate an ethical dimension into the values that
they stress. These values, which shape the way business is conducted both
within and by the corporation, have an important ethical component. Among other
things, they stress the need for confidence in and respect for people, open
communication, and concern for the individual employee.
Second, ethical values must be incorporated into the company’s
mission statement. Third, ethical values must be acted on. Top managers have to
implement hiring, firing and incentive systems that explicitly recognize the
importance of adhering to ethical values in strategic decision making.
Thinking
Through Ethical Problems
Besides establishing the right kind of ethical climate in an
organization, managers must be able to think through the ethical implications
of strategic decisions in a systematic way. A number of different frameworks
have been suggested as aids to the decision-making process.
In step 1— evaluating a proposed strategic decision from an
ethical standpoint— managers must identify which stakeholders the decision
would affect and in what ways. Most importantly, they need to determine if the
proposed decision would violate the rights of any stakeholders. The term rights
refers to the fundamental entitlements of a stakeholder. For example, one
might argue that the right to information about health risks in the workplace
is a fundamental entitlement of employees.
Step 2 involves judging the ethics of the proposed strategic
decision, given the information gained in step 1. This judgment should be
guided by various moral principles that should not be violated. The principles
might be those articulated in a corporate mission statement or other company
documents. In addition, there are certain moral principles that we have adopted
as members of society— for instance, the prohibition on stealing— and these
should not be violated. The judgment at this stage will also be guided by the
decision rule that is chosen to assess the proposed strategic decision.
Although long-run profit maximization is rightly the decision rule that most
companies stress, this decision rule should be applied subject to the
constraint that no moral principles are violated.
Step 3, establishing moral intent, means that the company must
resolve to place moral concerns ahead of other concerns in cases where either
the rights of stakeholders or key moral principles have been violated. At this
stage input from top management might be particularly valuable. Without the
proactive encouragement of top managers, middle-level managers might tend to
place the narrow economic interests of the company before the interests of
stakeholders. They might do so in the often erroneous belief that top managers
favor such an approach.
Step 4 requires the company to engage in ethical behavior.
Clearly, Johnson & Johnson fulfilled this requirement during the Tylenol
poisoning scare by pulling all of its product off retail stores shelves at
great cost to the company.
Corporate
Social Responsibility
Corporate social responsibility is a set of obligations an
organization has to enhance the society in which the business organization
operates. Corporate social responsibility is the series of obligation on the
part of companies to build certain social criteria into their strategic
decision making. The concept implies that when companies evaluate decisions
from an ethical prospective, there should be a presumption in favor of adopting
courses of action that enhance the welfare of society at large. The goals
selected might be quite specific: to enhance the welfare of communities in
which a company is based, improve the environment, or empower employees to give
them a sense of self worth.
Social Responsibility Approaches
There are four approaches that an organization can take enhancing
its obligations to the society that along a continuum ranging from lowest to
highest socially responsible practices.
Social obstruction is a social responsibility approach in which an organization does
as little as possible to enhance the society and solve the societal problems.
Social obligation is a social responsibility approach in which organizations do as
required of it legally but nothing more to enhance the society.
Social response is a sort social responsibility in which organizations meet the
basic ethical and social obligations and sometimes go beyond these in some
selected cases.
Social contribution is a social responsibility approach in which organizations view
them as the citizens and proactively come forward to address the social
problems.
The
External Environment The Five Forces Model
An industry can be defined as a group or companies offering
products or services that are close substitutes for each other. Close
substitutes are products or services that satisfy the same basic consumer
needs. For example, tea and coffee are close substitutes.
Managers have to analyze competitive forces in an industry
environment in order to identify opportunities and threats confronting to a
company. Michael E. Porter of the Harvard School of Business Administration has
developed a framework that helps managers in this analysis. Porter’s framework,
known as the five forces model focuses on five forces that shape competition
within an industry: (1) the risk of new entry by potential competitors, (2) the
degree of rivalry among established companies within an industry, (3) the
bargaining power of buyers, (4) the bargaining power of suppliers, and (5) the
closeness of substitutes to an industry’s products.
Potential
Competitors
Established companies try to discourage potential competitors from
entering, since the more companies enter an industry, the more difficult it
becomes for established companies to hold their share of the marker and to
generate profits. Thus a high risk of entry by potential competitors represents
a threat to the profitability of established companies. On the other hand, if
the risk of new entry is low, established companies can take advantage of this
opportunity to rise prices and earn greater returns.
The strength of the competitive force of potential rivals is
largely a function of the height of barriers to entry. The concept of barriers
to entry implies that there are significant costs to joining an industry. The
greater the costs that potential competitors must bear, the greater are the
barriers to entry. High entry barriers keep potential competitors out of an
industry, even when industry returns are high. The classic work on barriers to
entry was done by economist Joe Bain, who identified three main sources of
barriers to new entry: brand loyalty, absolute cost advantages, and economies
of scale.
Brand Loyalty: Brand loyalty is buyers’ preference for the products of
established companies. A company can create brand loyalty through continuous
advertising of brand and company names, parent protection of products, product
innovation through company research and development programs, an emphasis on
high product quality, and good after-sales service. Significant: brand loyalty
makes it difficult for new entrants to take marker share away from established
companies. Thus it reduces the threat of entry by potential competitors since
they may see the task of breaking down well-established consumer preferences as
too costly.
Absolute Cost Advantages: Lower absolute costs give established
companies an advantage that is difficult for potential competitors to match.
Absolute cost advantages can arise from superior production techniques. These
techniques can be due to past experience, patents, or secret processes, control
of particular inputs required for production, such as labor, materials,
equipment, or management skills, or access to cheaper funds because existing
companies represent lower risks than established companies. If established
companies have an absolute cost advantage, then again the threat of entry
decreases.
Economies of Scale: Economics of scale are the cost advantages associated with large
company size. Sources of scale economies include cost reductions gained through
mass-producing a standardized output, discounts on bulk purchases of
raw-material inputs and component parts, the spreading of fixed costs over a
large volume, and scale economics in advertising. If these cost advantages are
significant, then a new entrant faces the dilemma of either entering on a small
scale and suffering a significant cost disadvantage or taking a very large risk
by entering on a large scale and bearing significant capital costs. A further
risk of large-scale entry is that the increased supply of products w1il depress
prices and result in vigorous retaliation by established companies. Thus, when
established companies have economies of scale, the threat of entry is reduced.
Rivalry Among
Established Companies The second of Porters five competitive forces is the
extent of rivalry among established companies within an industry. If this
competitive force is weak, companies have an opportunity to raise prices and
earn greater profits. But if it is strong, significant price competition,
including price wars, may result from the intense rivalry. Price competition
limits profitability by reducing the margins. The extent of rivalry among
established companies within an industry is largely a function of three
factors: (1) Industry competitive structure, (2) demand conditions, and (3) the
height of exit barriers in the industry.
Competitive
Structure: Competitive
structure refers to the number and size distribution of companies in an
industry. Different competitive structures have different implications for
rivalry. Structures vary from fragmented to conso1idated. A fragmented industry
contains a large number of small or medium-sized companies, none of which is in
a position to dominate the industry. A consolidated industry is dominated by a
small number of large companies or, in extreme cases, by just one company (a
monopoly). Fragmented industries range from agriculture, video rental, and
health clubs, to real estate brokerage and suntanning parlors. Consolidated
industries include aerospace, automobiles, and pharmaceuticals. The range of
structures and their different characteristics are illustrated in the following
Figure:
Figure: The Continuum
of Industry Structures
Many fragmented
industries are characterized by low entry barriers and commodity type products
that are hard to differentiate. The combination of these traits tends to result
in boom-and-bust cycles. Low entry barriers imply that whenever demand is
strong and profits are high there will be a flood of new entrants hoping to
cash in on the boom. Often the flood of new entrants into a booming fragmented
industry creates excess capacity. Once excess capacity develops, companies
start to cut prices in order to utilize their spare capacity. The difficulty
companies face when trying to differentiate their products from those of
competitors can worsen this tendency. The result is a price war, which
depresses industry profits, forces some companies out of business and deters
potential new entrants.
In general, the
more commodity-like an industry’s product, the more vicious will be the price
war. This bust part of the cycle continues until overall industry capacity is
brought into line with demand (through bankruptcies), at which point prices may
stabilize again.
A
fragmented industry structure, then, constitutes a threat rather than an
opportunity. Most booms will be relatively short-lived because of the case of
new entry and will be followed by price war and bankruptcies. Since
differentiation is often difficult in these industries, the best strategy for a
company to pursue in such circumstances may be one of cost minimization. This
strategy allows a company to rack up high returns in a boom and survive any
subsequent bust.
The nature and intensity of competition for consolidated
industries are much more difficult to predict. The one certainty about
consolidated industries is that companies are interdependent—that is the
competitive actions of one company directly affect the profitability of others
in the industry.
Thus, in a consolidated industry, the competitive action of one
company directly affects the market share of its rivals, forcing a response
from them. The consequence of such competitive interdependence can be a
dangerous competitive spiral, with rival companies trying to undercut each
other’s prices, pushing industry profits down in the process.
Clearly, the interdependence of companies in consolidated
industries and the possibility of a price war constitute a major threat.
Companies often seek to reduce this threat by following the price lead set by a
dominant company in the industry. However, companies must be careful, for
explicit price-fixing agreements are illegal, although tacit agreements are
not. A tacit agreement is one arrived at without direct communication. Instead,
companies watch and interpret each other’s behavior. Normally, tacit agreements
involve following the price lead set by a dominant company.
Demand Conditions: Industry demand conditions are another determinant of the
intensity of rivalry among established companies. Growing demand tends to
moderate competition by providing greater room for expansion. Demand grows when
the market as a whole is growing through the addition of new consumers or when
existing consumers are purchasing more of an industry’s product. When demand is
growing, companies can increase revenues without taking market share away from
other companies. Thus growing demand gives a company a major opportunity to
expand operations.
Conversely, declining demand results in more competition as
companies fight to maintain revenues and market share. Demand declines when
consumers are leaving the marketplace or when each consumer is buying less.
When demand is declining, a company can attain growth only by taking market
share away from other companies. Thus declining demand constitutes a major
threat, for it increases the extent of rivalry between established companies.
Exit Barriers: Exit barriers are a serious competitive threat when industry
demand is declining. Exit barriers are economic, strategic, and emotional
factors that keep companies competing in an industry even when returns are low.
If Exit barriers are high, companies can become locked into an unfavorable
industry. Excess productive capacity can result. In turn, excess capacity rends
to lead to intensified price competition, with companies cutting prices in an
attempt to obtain the orders needed to utilize their idle capacity. Common exit
barriers include the following:
1.
Investments in plant and equipment that have no alternative uses
and cannot be sold off. If a company wishes to leave the industry, it has to
write off the book value of these assets.
2.
High fixed costs of exit, such as severance pay to workers who are
being made redundant
3.
Emotional attachments to an industry, as when a company is
unwilling to exit from its original industry for sentimental reasons.
4.
Strategic relationships between business units. For example,
within a multi industry company, a low-return business unit may provide vital
inputs for a high-return business unit based in another industry. Thus the
company may be unwilling to exit from the low-return business.
5.
Economic dependence on the industry, as when a company is not
diversified and so relies on the industry for its income.
The Bargaining Power of Buyers The third of Porter’s five competitive
forces is the bargaining power of buyers. Buyers can be viewed as a competitive
threat when they force down prices or when they demand higher quality and
better service (which increase operating costs). Alternatively, weak buyers
give a company the opportunity to raise prices and earn greater returns.
Whether buyers are able to make demand on a company depends on their power
relative to that of the company. According to Porter, buyers are most powerful
in the following circumstances:
1.
When the supply industry
is composed of many small companies and the buyers are few in number and large.
These circumstances allow the buyers to dominate supply companies.
1.
When the buyers
purchase in large quantities. In such circumstances, buyers can use their
purchasing power as leverage to bargain for price reductions.
1.
When the supply
industry depends on the buyers for a large percentage of its total orders.
1.
When the buyers can
switch orders between supply companies at a low cost, thereby playing off
companies against each other to force down prices.
1.
When it is
economically feasible for the buyers to purchase the input from several
companies at once.
1.
When the buyers can
use the threat to supply their own needs through vertical integration as a
device for forcing down prices.
The
Bargaining Power of Suppliers
The fourth of Porter’s competitive forces is the bargaining power
of suppliers. Suppliers can be viewed as a threat when they are able to force
up the price that a company must pay for input or reduce the quality of goods
supplied, thereby depressing the company’s profitability. Alternatively, weak
suppliers give a company the opportunity to force down prices and demand higher
quality. As with buyers, the ability of suppliers to make demands on a company
depends on their power relative to that of the company. According to Porter
suppliers are most powerful in the following circumstances:
1.
When the product that suppliers sell has few substitutes and is
important to the company.
2.
When the company’s industry is not an important customer to the
suppliers. In such instances, the suppliers’ health does not depend on the
company’s industry, and suppliers have little incentive to reduce prices or
improve quality.
3.
When supplier’s respective products are differentiated to such an
extent that it is costly for a company to switch from one supplier to another.
In such cases, the company depends on its suppliers and cannot play them off
against each other.
4.
When, to raise prices, suppliers can use the threat of vertically integrating
forward into the industry and competing directly with the company.
5.
When buying companies cannot use the threat of vertically
integrating backward and supplying their own needs as a means to reduce input
prices.
The
Threats of Substitute Products
The final force in Porter’s model is the threat of substitute
products— the products of industries that serve similar consumer needs as those
of the industry being analyzed. For example, companies in the coffee industry
compete indirectly with those in the tea and soft-drink industries. (All three
industries serve consumer needs for drinks.) The prices that companies in the
coffee industry can charge are limited by the existence of substitutes such as
tea and soft drinks. If the price of coffee rises too much relative to that of
tea or soft drinks, then coffee drinkers will switch from coffee to those
substitutes.
The existence of close substitutes presents a strong competitive
threat, limiting the price a company can charge and thus its profitability.
However, if a company’s products have few close substitutes (that is, if
substitutes are a weak competitive force), then, other things being equal, the
company has the opportunity to raise prices and earn additional profits.
Consequently, its strategies should be designed to take advantage of this fact.
The
Role of the Macroenvironment
So far we have treated industries as self-contained entities, yet
in practice they are embedded in a wider Macro environment. That is, the
broader economic, technological, demographic, social, and political environment
(Shown in the following Figure). Changes in the macroenvironment can have a
direct impact on any one of the five forces in Porter's model, thereby altering
the relative strength of these forces and with it, the attractiveness of an
industry.
Figure:
The Role of Macro environment
The Macroeconomic Environment: The state of the macroeconomic
environment determines the general health and well-being of the economy. This
in turn affects a company’s ability to earn an adequate rate of return. The
four most important macroeconomic indicators in this context are the growth
rate of the economy, the interest rates, currency exchange rates, and inflation
rates.
Because it leads to an expansion in consumer expenditure, economic
growth tends to produce a general easing of competitive pressures within an
industry. This gives companies the opportunity to expand their operations.
Because economic decline leads to a reduction in consumer expenditure, it
increases competitive pressures. Economic decline frequently causes price wars
in mature industries.
The level of interest rates can determine the level of demand for
a company’s products. Interest rates are important whenever consumers routinely
borrow money to finance their purchase of these products. Rising interest rates
are a threat and falling rates an opportunity.
Currency exchange rates define the value of different national
currencies against each other. Movement in currency exchange rates has a direct
impact on the competitiveness of a company’s products in the global
marketplace. For example, when the value of the dollar is low compared with the
value of other currencies, products made in the United States
Inflation can destabilize the economy, producing slower economic
growth, higher interest rates, and volatile currency movements. If inflation
keeps increasing, investment planning becomes hazardous. The key characteristic
of inflation is that it makes the future less predictable. In an inflationary
environment, it may be impossible to predict with any accuracy the real value
of returns that can be earned from a project five years hence. Such uncertainty
makes companies less willing to invest. Their holding back in turn depresses
economic activity and ultimately pushes the economy into a slump. Thus high inflation
is a threat to companies.
The Technological Environment: Technological change can make
established products obsolete overnight. At the same time it can create a host
of new product possibilities. Thus it is both creative and destructive— both an
opportunity and a threat. One of the most important impacts of technological
change is that can affect barriers to entry and as a result, radically reshape
industry structure.
The Social Environment: Like technological change, social change creates opportunities and
threats. One of the major social movements of the 1970s and 1980s was the trend
toward greater health consciousness. Its impact has been immense, and companies
that recognized the opportunities early have often reaped significant gains.
For example, the Coca-Cola Company, by introducing diet colas and fruit-based
soft drinks first, capitalized on the growing health trend and was able to gain
market share. At the same time the health trend has created a threat for many
industries. The tobacco industry, for example is now in decline as a direct
result of greater consumer awareness of the health implications of smoking.
Similarly, the sugar industry has seen sales decrease as consumers have decided
to switch to artificial sweeteners.
The Demographic Environment: The changing composition of the
population is another factor that can create both opportunities and threats.
For example, as the baby-boom generation of the 1960s has moved through the
population, it has created a host of opportunities and threats. Currently, baby
boomers are getting married and creating an upsurge in demand for the consumer
appliances normally bought by couples marrying for the first time. Thus
companies such as Whirlpool Corporation and General Electric Co. are looking to
capitalize on the predicted upsurge in demand for washing machines,
dishwashers, spin dryers, and the like. The other side of the coin is that
industries oriented toward the young, such as the toy industry, have seen their
consumer base decline in recent years.
The Political and Legal Environment: Political and legal
factors also have a major effect on the level of opportunities and threats in
the environment. One of the most significant trends in recent years has been
the move toward deregulation. By eliminating many legal restrictions,
deregulation has lowered barriers to entry and opened a number of industries to
intense competition. The deregulation of the airline industry, for example,
created the opportunity to establish low-fare carriers— an opportunity that
Texas Air, and others tried to capitalize on. At the same time the increased
intensity of completion created many threats, including, most notably, the
threat of prolonged fare wars, which have repeatedly thrown the airline
industry into turmoil during the last decade.
For the future, fears about the destruction of the ozone layer,
acid rain and global warming may be near the top of the political agenda. Given
these concerns, governments seem increasingly likely to enact tough
environmental regulations to limit air pollution.
Strategic
Groups within Industries
The Concept of Strategic Groups: In practice,
companies in an industry often differ from each other with respect to factors
such as distribution channels used, market segments served, product quality,
technological leadership, customer service, pricing policy, advertising policy,
and promotions. Within most industries, it is possible to observe groups of
companies in which each member follows the same basic strategy as other
companies in the group but a strategy different from the one followed by
companies in other groups. These groups of companies are known as strategic
groups.
Normally, a limited number of groups capture the essence of
strategic differences between companies within an industry. For example, in the
pharmaceutical industry two main strategic groups stand out (see the following
Figure). One group, which includes such companies as Merck, Eli Lilly and
Pfizer, is characterized by heavy R&D spending and a focus on developing new
proprietary blockbuster drugs. The companies in this proprietary group are
pursuing a high-risk/high-return strategy. It is a high-risk strategy because
basic drug research is difficult and expensive. It is also a high-return
because they can charge high prices as the innovator has monopoly on its
production and sale.
Figure:
Strategic Groups in the Pharmaceutical Industry
The second strategic group might be characterized as the generic
drug group. This group of companies, which includes Marion Labs, ICN Pharmaceuticals,
and Carter Wallace, focuses on the manufacture of generic drugs— low-cost
copies of drugs pioneered by companies in the proprietary group whose patents
have now expired. The companies in this group are characterized by low R&D
spending and an emphasis on price competition. They are pursuing a low-risk,
low-return strategy. It is low risk because they are not investing millions of
dollars in R&D. It is low-return because they cannot charge high prices.
Implications of Strategic Groups: The concept of
strategic groups has a number of implications for industry analysis and the
identification of opportunities and threats. First, a company’s immediate
competitors are those in its strategic group. Since all the companies in a
strategic group are pursuing similar strategies, consumers tend to view the
products of such enterprises as being direct substitutes for each other. Thus a
major threat to a company’s profitability can come from within its own
strategic group.
Second, different strategic groups can have a different standing
with respect to each of Porter’s five competitive forces. In other words, the
risk of new entry by potential competitors, the degree of rivalry among
companies within a group, the bargaining power or buyers, the bargaining power
of suppliers, and the competitive force of substitute products can all vary in
intensity among different strategic groups within the same industry.
Third, some strategic groups are more desirable than others, for
they have lower level of threats and greater opportunities. If the environment
of one strategic group is more favorable, then moving into that group can be
regarded as an opportunity. But moving to another strategic groups involve
costs due to mobility barriers. Mobility barriers are factors that inhibit the
movement of companies between groups in an industry. They include broth the
barriers to entry into a group and the barriers to exit from a company’s
existing group. A company planning entry into another strategic group must
evaluate the height of mobility barriers before deciding whether the move is
worthwhile.
Mobility barriers also imply that companies within a given group
may be protected to a greater or lesser extent from the threat of entry by
companies based in other strategic groups. If mobility barriers are low, then
the threat of entry from companies in other groups may be high, effectively
limiting the prices companies can charge and the profits they can earn without
attracting new competition. If mobility barriers are high, then the threat of
entry is low, and companies within the protected group have an opportunity to
raise prices and earn higher returns without attracting entry.
Limitations
of the Five Forces and Strategic Group Models
The five forces and strategic group models constitute very useful
ways of thinking about and analyzing the nature of competition within an
industry. However, managers need to be aware of their shortcomings. Both models
(1) present a static picture of competition which slights the role of innovation
and (2) de-emphasize the significance of individual company differences while
overemphasizing the importance of industry and strategic group structure as
determinants of company profit rates.
Static Model in a Dynamic World: Over any reasonable
length of time, in many industries competition can be viewed as a process
driven by innovation. Companies that pioneer new products processes or
strategies can often earn enormous profits. This prospect gives companies a
strong incentive to seek innovative products, processes, and strategies.
Successful innovation can revolutionize industry structure. In recent decades
one or the most common consequences of innovation has been to lower the fixed
costs or production, thereby reducing barriers to entry and allowing new, and
smaller, enterprises to compete with large established organizations.
But both the five forces and strategic group models present a
static picture of competition which ignores the role of innovation. The five
forces and strategic group models are applicable while the industry is in a
steady state bur not while it is undergoing radical restructuring due to
innovation or some other discontinuity. (Deregulation of an industry is another
example of a discontinuity.) Because the five forces and strategic group models
are static they cannot adequately capture what occurs during such periods of
rapid change, but they are certainly useful tools for analyzing industry
structure during periods of stability.
Industry Structure and Company Difference: The second criticism
of the five forces and strategic group models is that they overemphasize the
importance of industry structure as a determinant of company performance and
underemphasize the importance of differences between companies within an
industry or strategic group. But studies suggest that the individual resources
and capabilities of a company are far more important determinants of its
profitability than is the industry or strategic group of which the company is a
member. Although these findings do not make the five forces and strategic group
models irrelevant, they do mean that the models have limited usefulness. A
company will not be profitable just because it is based in an attractive
industry or strategic group; much more is required.
Competitive
Changes During Industry Evolution
Over time most industries pass through a series of well-defined
stages, from growth through maturity and eventually into decline. These stages
have different implications for the form of competition. The strength and
nature of each of Porter’s five competitive forces typically changes as an
industry evolves. This is particularly true regarding potential competitors and
rivalry, and we focus on these two forces in our discussion. The changes in the
strength and nature of these forces give rise to different opportunities and
threats at each stage of an industry’s evolution.
The industry life cycle model is a useful tool for analyzing the
effect of industry evolution on competitive forces. The model is similar to the
product life cycle model discussed in the marketing literature. Using the
industry life cycle model we can identify five industry environments, each
linked to a distinct stage of an industry evolution: (1) an embryonic industry
environment, (2) a growth industry environment, (3) a shakeout environment, (4)
a mature industry environment, and (5) a declining industry environment (see
the following Figure).
Figure:
Stages of Industry Life Cycle
Embryonic Industry: An embryonic industry is one that is just beginning to develop.
Growth at this stage is slow because of such factors as buyers’ unfamiliarity
with the industry’s product, high prices due to the inability of companies to
reap any significant scale economies, and poorly developed distribution
channels. Barriers to entry at this stage in an industry’s evolution tend to be
based on access to key technological know-how rather than cost economies or
brand loyalty. If the core know-how required to compete in the industry is
complex and difficult to grasp, barriers to entry can be quite high and
incumbent companies will be protected from potential competitors. Rivalry in
embryonic industries is based not so much on price as upon educating customers,
opening up distribution channels, and perfecting the design of the product.
Such rivalry can be intense, and the company that is first to solve design
problems often has the opportunity to develop a significant market position. An
embryonic industry may also be the creation of one company’s innovative
efforts, as happened with personal computers (Apple), and photocopiers (Xerox).
In such circumstances, the company has a major opportunity to capitalize on the
lack of rivalry and build up a strong hold on the market.
Growth Industries: Once demand for the industry’s product begins to take off, the
industry develops the characteristics of a growth industry. In a growth
industry, first-time demand is expanding rapidly as many new consumers enter
the market. Typically, an industry grows when consumers become familiar with
the product, when prices fall because experience and scale economies have been
attained, and when distribution channels develop.
Normally, the importance of control over technological knowledge
as a barrier to entry diminishes by the time an industry enters its growth
stage. Because few companies have yet achieved significant scale economies or
differentiated their product sufficiently to guarantee brand loyalty, other
barriers to entry tend to be low as well. Consequently, the threat from
potential competitors generally is highest at this point. Paradoxically,
though, high growth usually means that new entrants can be absorbed into an
industry without a marked increase in competitive pressure.
During an industry’s growth stage, rivalry tends to be low. Rapid
growth in demand enables companies to expand their revenues and profits without
taking market share away from compactors. A company has the opportunity to
expand its operations. In addition, a strategically aware company takes
advantage of the relatively favorable environment of the growth stage to
prepare itself for the intense completion of the coming industry shakeout.
Industry Shakeout: Explosive growth cannot be maintained indefinitely. Sooner or
later the rate of growth slows, and the industry enters the shakeout stage. In
the shakeout stage, demand approaches saturation levels. In a saturated market,
there are few potential first-time buyers left. Most of the demand is limited
to replacement demand.
As an industry enters the shakeout stage, rivalry between
companies becomes intense. What typically happens is that companies that have
become accustomed to rapid growth during an industry’s growth phase continue to
add capacity at rates consistent with past growth. Managers use historic growth
rates to forecast future growth rates, and they plan expansions in productive
capacity accordingly. As an industry approaches maturity, however, demand no
longer grows at historic rates. The consequence is the emergence of excess
productive capacity. This condition is illustrated in the following Figure,
where the solid curve indicates the growth in demand over time and the broken
curve indicates the growth in productive capacity over time. As we can see,
past point t1, the growth in demand slows as the industry becomes mature.
However, capacity continues to grow until time t2. The gap between
the solid and the broken lines signifies excess capacity. In an attempt to
utilize this capacity, companies often cut prices. The result can be an intense
price war, which drives many of the most inefficient companies into bankruptcy.
This is itself enough to deter new entry.
Figure: Growth in
Demand and Capacity
Mature Industries: The shakeout stage ends when the industry enters its mature stage.
In a mature industry, the market is totally saturated and demand is limited to
replacement demand. During this stage, growth is low or zero. What little
growth there is comes from population expansion bringing new consumers into the
market.
As an industry enters maturity, barriers to entry increase and the
threat of entry from potential competitors decreases. As growth slows during
the shakeout, companies can no longer maintain historic growth rates merely by
holding on to their market share. Competition for market share develops, driving
down prices. Often the result is a price war. To survive the shakeout,
companies begin to focus both on costs minimization and on building brand
loyalty. By the time an industry matures, the surviving companies are those
that have brand 1oyalty and low-cost operations. Because both of these factors
constitute a significant barrier to entry, the threat of entry by potential
competitors the greatly diminished. High entry barriers in maturity industries
give companies the opportunity to increase prices profits. As a result of the
shakeout, most industries in the maturity stage have consolidated and become
oligopolies.
Declining Industries: Eventually, most industries enter a decline stage. In the decline
stage, growth becomes negative for a variety of reasons, including
technological substitution (for example, air travel for rail travel), social
changes (greater health consciousness hitting tobacco sales), demographics (the
declining birthrate hurting the market for baby and child products), and
international competition. Within a declining industry, the degree of rivalry
among established companies usually increases. Depending on the speed of the
decline and the height of exit barriers, competitive pressures can become as
vicious as in the shake out stage. The main problem in a decline industry is
that falling demand leads to the emergence of excess capacity. In trying to
utilize this capacity, companies begin to cut prices, thus sparking a price
war. Exit barriers play a part in adjusting excess capacity. The greater the
exit barriers, the harder it is for companies to reduce capacity and the
greater is the threat of severe price competition.
Variations on the Theme: It is important to remember that the industry life cycle model is
a generalization. In practice, industry life cycles do not always follow all
the stages. In some cases, growth is so rapid that the embryonic stage is
skipped altogether, as happened in the personal computer industry. In other
instances, industries fail to get past the embryonic stage. Industry growth can
be revitalized after long periods of decline, either through innovations or
through social changes. The time span of the different stages can also vary,
significantly from industry to industry. Some industries can stay in maturity almost
indefinitely if their products become basic necessities of life, as is the case
for the automobile industry. Others skip the mature stage and go straight into
decline. Still other industries may go through not one but several shakeouts
before they enter full maturity.
Globalization
and Industry Structure
Globalization involves both the globalization of production and of
markets. The globalization of production refers to the dispersion of parts of
production process to different locations around the globe to take advantage of
national differences in the cost and quality of factors to production (that is,
labor, energy, land, and capital). The objective is to lower costs and boost
profits.
The globalization of markets refers to away from an economic system
in which national markets are distinct entities, isolated from each other by
trade barriers and barriers of distance, time, and culture, and toward a system
in which national markets are merging into one huge global marketplace.
According to this view, the tastes and preferences of consumers in different
nations are beginning to come together on some global norm.
The Causes of Global Shift:
Two factors underlie the trend toward the increasing globalization
of markets and production. Since the end of World War II, barriers to the free
flow of goods, services, and capital between countries have decreased, and
dramatic changes have occurred in communication, information, and
transportation technologies.
In the aftermath of World War II, the advanced industrial nations
of the West committed themselves to the goal of removing barriers to the free
flow of goods, services, and capital between nations. The goal of removing
barriers to the free flow of goods was enshrined in an international treaty
known as the General Agreement on Tariffs and Trade (GATT). Under the umbrella
of the GATT, in the half century since World War II there has been a
significant lowering of barriers to the free flow of goods.
The result of the GATT has, been to facilitate the globalization
of markets and production. The lowering of trade barriers has allowed companies
to view the world, rather than a single country, as their market. It has also
made it increasingly possible to base individual production activities at the
optimal locations for them, serving the world market from those locations. Thus
a company might design a product in one country, produce component parts in two
other counters, assemble the product in yet another country, and then export
the finished product around the world.
If the lowering of trade barriers made the globalization of
markets and production a theoretical possibility, technological change has
transformed this into a tangible reality. Perhaps the single most important
innovation has been the development of the microprocessor, which underlies many
of the recent advances in communications technology, information processing and
transportation technology. These technological innovations have dramatically
lowered the real costs of information processing and communications over the
last two decades. Lower costs in turn have made it possible for companies to
manage globally dispersed production systems. Indeed, a worldwide
communications network has become essential to the functioning of many
companies.
Besides communications and information-processing technology the
development commercial jet aircraft has helped knit together the worldwide
operations of many international businesses. By jetliner, it takes a day at
most for an American manager to travel to her company’s European or Asian
operations, greatly increasing her ability to oversee a globally dispersed
production system.
Technological innovation has also facilitated the globalization of
markets. Low-cost jet travel has resulted in the mass movement of people
between countries. This has helped reduce the cultural distance between
countries and has laid the ground for some convergence of consumer tastes and
preferences. At the same time global communications networks and global media
are helping to create a worldwide culture.
The Consequences of Global Shift:
The trend toward the globalization of production and the
globalization of markets has several important implications for competition
within an industry. First, it is crucial for companies to recognize that
industry boundaries do not stop at national borders. Because many industries
are becoming global in scope, actual and potential competitors exist not only
in a company’s home market bur also in other national markets. Companies that
scan just their home market can be caught unprepared by the entry of efficient
foreign competitors.
Second, the shift from national to global markets during the last
twenty years has intensified competitive rivalry in industry after industry.
National markets that were once consolidated oligopolies, dominated by three or
four companies and subjected to relatively little foreign competition, have
been transform into segments of fragmented global industries, where a large
number of companies battle each other for market share in country after
country. This rivalry has driven down profit rates and made it all the more
critical for companies to maximize their efficiency, quality, customer
responsiveness, and innovative ability.
Third, as competitive intensity has increased, so has the rate of
innovation. Companies strive to gain an advantage over their competitors by
pioneering new products, processes, and ways of doing business. The result has
been to compress product life cycles and make it viral for companies to stay on
the leading edge of technology.
Finally, it should be noted that even though globalization has
increased both the threat of entry and the intensity of rivalry within many
formerly protected national markets, it has also created enormous opportunities
for companies based in those markets. The steady decline in trade barriers has
opened up many once protected markets to companies based outside them.
National
Context and Competitive Advantage
The national context of a country influences the competitiveness
of companies based within it. Despite the globalization of production and
markets, many of the most successful companies in certain industries are still
clustered in a small number of countries. The national context within which a
company is based may have an important bearing on the competitive position of
that company in the global market place.
Companies need to understand how national context can affect
competitive advantage, for then they will be able to identify (1) where their
most significant competitors are likely to come from and (2) where they might
want to locate certain productive activities.
Economic theory stresses that factor conditions— the cost and
quality of factors of production— are a prime determinant of the competitive
advantage that certain countries might have in certain industries. Factors of
production include basic factors, such as land, labor, capital, and raw
materials, and advanced factors such as technological know-how-managerial
sophistication, and physical infrastructure (that is, roads, railways, and
ports).
According to Porter there are four basic determinants of a
nation’s competitive position in certain industries: factor conditions,
industry rivalry, demand conditions, and related and supporting industries (see
the following Figure).
Figure:
The Determinants of National Competitive Advantage
He argues that a country will have a competitive advantage in a
particular industry under the following conditions:
1.
The country has the right mix of basic and advanced factors of
production to support that industry.
2.
Intense rivalry between local companies in that industry has
forced them to be efficient.
3.
Strong local demand conditions have helped foster a strong local
industry, while demanding consumers have forced companies to become more
efficient.
4.
Related and supporting industries are also internationally
competitive, thus providing companies in the focal industry with low-cost and
high-quality inputs and complementary products.
Competitive
Advantage: Resources, Capabilities, and Competencies Overview
Competitive advantage comes from an ability to lower costs through
high efficiency, provide consistently high quality products, and be responsive
to customer needs. Efficiency, quality, innovation, and customer responsiveness
can be regarded as the four main building blocks, or dimensions, of competitive
advantage. Companies that have achieved a competitive advantage typically excel
on at least one of these four main dimensions. In turn, these dimensions are
the product of an organization’s competencies, resources, and capabilities.
Competitive
Advantage: Low Cost and Differentiation
We say that a company has a competitive advantage when its profit
rate is higher than the average for its industry. Profit rare is normally
defined as some ratio, such as return on sales (ROS) or return of assets (ROA).
The most basic determinant of a company’s profit rare is its gross
profit margin (Π), which is simply the difference between total revenues (TR)
and total costs (TC), divided by total costs:
Π = (TR – TC)/TC
To put it another way,
Π = {(Unit Price x
Unit Sales) – (Unit Cost x Unit Sales)}/(Unit Cost x Unit Sales).
It allows that for a gross profit margin to be higher than the
average for the industry one of the following must be occurring:
The company’s unit
price must be higher than that of the average company and its unit cost must be
equivalent to that of the average company.
The company’s unit
cost must be lower than that of the average company and its unit price must be
equivalent to that of the average company.
The company must have
both a lower unit cost and a higher unit price than the average company.
Thus, to achieve a competitive advantage, a company must either
have lower costs than its competitors, or it must differentiate its products in
some way so that it can charge a higher price than its competitors, or it must
do both simultaneously.
When a company charges a higher unit price than the industry
average, it is engaging in premium pricing. For a consumer to be prepared to
pay a premium price, the company must be adding value to the product, from the
consumer’s perspective, in a way that competitors are not. Adding value
requires differentiating the product from those offered by competitors along
one or more dimensions, such as quality, design, delivery time and after-sales
services and support.
Building on these basic ideas, Michael Porter has referred to low
cost and differentiation as generic business-level strategies. That is, the
strategies represent the two fundamental ways of trying to obtain a competitive
advantage in an industry. A low-cost strategy is based on doing everything
possible to lower unit costs. A differentiation strategy is based on doing
everything possible to differentiate products from those offered by competitors
in order to be able to charge a premium price.
The Generic
Building
Figure:
Generic Building Blocks of Competitive Advantage
Efficiency: A company is a device for transforming inputs into outputs. Inputs
are basic factors of production such as labor, land, capital, management,
technological know-how, and so on. Outputs are the goods and services that a
company produces. Efficiency is measured by the cost of inputs required to
produce a given output. The more efficient a company, the lower is the cost of
inputs required to produce a given output. Thus efficiency helps a company
attain a low-cost competitive advantage.
One of the keys to achieving high efficiency is to utilize inputs
in the most productive way possible. The most important component of efficiency
for most companies is employee productivity, which is usually measured by
output per employee. Holding all else constant, the company with the highest
employee productivity in an industry will typically have the lowest costs of
production.
Quality: Quality products are goods and services that are reliable in the
sense that they do the job they were designed for and do it well. The impact of
high product quality on competitive advantage is twofold. First, providing
high-quality products creates a brand name reputation for a company’s products.
In turn, this enhanced reputation allows the company to charge a higher price
for its products.
The second impact of quality on competitive advantage comes from
the greater efficiency, and hence lower unit costs brought about by higher
product quality. The major effect here is through the impact of quality on
productivity. Higher product quality means that less employee time is wasted
making defective products or providing substandard services and less time has
to be spent fixing mistakes. This translates into higher employee productivity
and lower unit costs. Thus high product quality not only lets a company charge
higher prices for its product; it also lowers costs (Shown in the following
Figure).
Figure: Impact of
Quality on Profits
Innovation: Innovation can be defined as anything new or novel about the way a
company operates or the products it produces. Thus innovation includes advances
in the kinds of products, production processes, management systems,
organizational structures, and strategies developed by a company.
Innovation is perhaps the single most important building block of
competitive advantage. In the long run, competition can be viewed as a process
driven by innovation. Although not all innovations succeed, those that do can
be a major source of competitive advantage. The reason is that, by definition,
successful innovation gives a company something unique— something that its
competitors lack (until they imitate the innovation). Thus, uniqueness may
allow a company to differentiate itself from its rivals and charge a premium
price for its product. Alternatively, it may allow a company to reduce its unit
costs far below those of competitors.
Customer Responsiveness: To achieve customer responsiveness, a company must give its
customers exactly what they want when they want it. Consequently, a firm must
do everything possible to identify customer needs and to satisfy them. Among
other things, achieving superior customer responsiveness involves giving
customers value for money. Steps taken to improve the efficiency of a company’s
production process and the quality of its output are consistent with this goal.
In addition, satisfying customer needs may require the development of new
products with features that existing products lack. In other words, achieving
superior efficiency, quality, and innovation are all part of achieving superior
customer responsiveness.
Another factor that stands out in any discussion of customer
responsiveness is the need to customize goods and services to the unique
demands of individual customers. For example, the production of different types
of soft drinks and beers in recent years can be viewed partly as a response to
this trend.
An aspect of customer responsiveness that has drawn increasing
attention is customer response time—the time that it takes for a good to be delivered
or a service to be performed.
Besides quality, customization, and response time, other sources
of enhanced customer responsiveness are superior design, superior service, and
superior after sales service and support. All these factors enhance customer
responsiveness and allow a company to differentiate itself from its less
responsive competitors. In turn, differentiation enables a company to build
brand loyalty and to charge premium price for its products.
Summary: Efficiency, quality, customer responsiveness, and innovation are
all important elements in obtaining a competitive advantage. Superior
efficiency enables a company to lower its costs; superior quality lets both
charge a higher price and lower its costs; superior customer responsiveness allows
it to charge a higher price; and superior innovation can lead to higher prices
or lower unit costs (Shown in the following Figure). Together, these four
factors create a low-cost or differentiation advantage for a company, which
brings above average profits and enables it to outperform its competitors.
Figure:
Impact of Efficiency, Quality, Customer Responsiveness, and Innovation on Unit
Costs and Prices
Distinctive
Competencies, Resources, and Capabilities
A distinctive
competency refers to a unique strength that allows a company to achieve
superior efficiency, quality, innovation, or customer responsiveness (Shown in
the following Figure). A firm with a distinctive competency can charge a
premium price for its products or achieve substantially lower costs than its
rivals. Consequently, it can earn a profit rate substantially above the
industry average.
Resources and Capabilities: The distinctive competencies of an
organization arise from two complementary sources: its resources and capabilities.
Resources refer to the financial, physical, human, technological, and
organizational resources of the company. These can be divided into tangible
resources (land- buildings, plant, and equipment) and intangible resources
(brand names, reputation, patents, and technological or marketing know-how). To
give rise to a distinctive competency a company’s resources must be both unique
and valuable. A unique resource is one that no other company has. For example,
Polaroid’s distinctive competency in instant photography was based on a unique
intangible resource: the technological know-how involved in instant film
processing. This know-how was protected from imitation by a thicker of patents.
A resource is valuable if it in some way helps create strong demand for the
company’s products. Thus Polaroid’s technological know-how was valuable because
it created strong demand for its photographic products.
Capabilities refer to a company’s skills at coordinating its
resources and putting them to productive use. These skills reside in an
organization’s routines, that is, in the way a company makes decisions and
manages its internal processes in order to achieve organizational objectives.
More generally, a company’s capabilities are the product of its organizational
structure and control systems. These specify how and where decisions are made
within a company, the kind of behaviors the company rewards, and the company’s
cultural norms and values.
The
Durability of Competitive Advantage
We need to address
that how long will a competitive advantage last once it has been created. The
durability of a company’s competitive advantage depends on three factors: the
height of barriers to imitation, the capability of competitors to imitate its
innovation, and the general level of dynamism in the industry environment.
Figure:
Factors Influencing the Durability of Competitive Advantage
Barriers to
Imitation: Barriers to imitation are factors that make it difficult for a
competitor to copy a company’s distinctive competencies. Since distinctive
competencies allow companies to earn superior profits, competitors want to
imitate them. However, the greater the barrier to such imitation, the more
sustainable is a company’s competitive advantage. It is important to note at
the outset that ultimately almost any distinctive competency can be imitated by
a competitor. The critical issue is time. The longer it takes competitors to
imitate a distinctive competency, the greater the opportunity that the company
has to build a strong market position and reputation with consumers, which is
then difficult for competitors to attack. Moreover, the longer it takes to
achieve an imitation, the greater is the opportunity for the imitated company
to improve on its competency, or build other competencies, thereby staying one
step ahead of the competition.
Imitating Resources: The easiest distinctive competencies for prospective rivals to
imitate tend to be those based on possession of unique and valuable tangible
resources, such as buildings, plant, and equipment. Such resources are visible
to competitors and can often be purchased on the open market.
Intangible resources can be more difficult to imitate. This is
particularly true of brand names. Brand names are important because they
symbolize a company’s reputation. Customers will often display a preference for
the products of such companies because the brand name is an important guarantee
of high quality. Although competitors might like to imitate well -established
brand names, the law prohibits them from doing so.
Marketing and technological know-how are also important intangible
resources. Unlike brand names, however, company-specific marketing and
technological know-how can be relatively easy to imitate. In the case of
marketing know-how, the movement of skilled marketing personnel between
companies may facilitate the general dissemination of know-how. With regard to
technological know-how, in theory, the patent system should make technological
know-how relatively immune to imitation. Patents give the inventor of a new
product a seventeen-year exclusive production agreement.
Imitating Capabilities: Imitating a company’s capabilities tends to be more difficult than
imitating its tangible and intangible resources, chiefly because a company’s
capabilities are often invisible to outsiders. Since capabilities are based on
the way in which decisions are made and processes are managed deep within a
company, by definition, it is hard for outsiders to discern the nature of a
company’s internal operations.
On its own, however, the invisible nature of capabilities would
not be enough to halt imitation. In theory, competitors could still gain
insights into how a company operates by hiring people away from that company.
However, a company’s capabilities rarely reside in a single individual. Rather,
they are the product of how numerous individuals interact within a unique
organizational setting. It is possible that no one individual within a company
may be familiar with the totality of a company’s internal operating routines
and procedures. In such cases, hiring people away from a successful company in
order to imitate its key capabilities may not be helpful.
To sum up, since resources are easier to imitate than
capabilities, a distinctive competency based on a company’s unique capabilities
is probably more durable (less imitable) than one based on its resources. It is
more likely to form the foundation for a long-run competitive advantage.
Capability of Competitors: According to work by Pankaj Ghemawat, a
major determinant of the capability of competitors to rapidly imitate a
company’s competitive advantage is the nature of the competitors’ prior
strategic commitments. By strategic commitment, Ghemawat means a company’s
commitment to a particular way of doing business— that is, to developing a
particular set of resources and capabilities. Ghemawat’s point is that once a
company has made a strategic commitment it will find it difficult to respond to
new competition if doing so requires a break with this commitment. Therefore,
when competitors already have long-established commitments to a particular way
of doing business, they may be slow to imitate an innovating company’s
competitive advantage. Its competitive advantage will thus be relatively
durable.
Industry Dynamism: A dynamic industry
environment is one that is changing rapidly. We examined the factors that
determine the dynamism and intensity of competition in an industry. The most
dynamic industries tend to be those with a very high rate of product
innovation— for instance, the consumer electronics industry and the personal
computer industry. In dynamic industries, the rapid rate of innovation means
that product life cycles are shortening and that competitive advantage can be
transitory (temporary). A company that has a competitive advantage today may
find its market position outflanked tomorrow by a rival’s innovation.
Why Do Companies Fail? We define a failing company as one whose profit rare is
substantially lower than the average profit rate of its competitors. A company
can lose its competitive advantage bur still nor fail. It may just earn average
profits. Failure implies something more drastic. Failing companies typically
earn low or negative profits; in other words, they are at a competitive
disadvantage. We explore three related reasons for failure: inertia, prior
strategic commitments, and the Icarus paradox.
Inertia: The inertia argument is that companies find it difficult to change
their strategies and structures in order to adapt to changing competitive
conditions.
The role of an organization’s capabilities can cause inertia.
Earlier we argue that organizational capabilities can be a source of
competitive advantage; their downside, however, is that they are difficult to
change. Recall that capabilities are the way a company makes decisions and
manages its processes. Capabilities are difficult to change because a certain
distribution of power and influence is embedded within the established
decision-making and management processes of an organization. Those who play key
roles in a decision-making process clearly have more power. It follows that
changing the established capabilities of an organization means changing its
existing distribution of power and influence, and those whose power and
influence would diminish resist such change. Proposals for change trigger turf
battles. This power struggle and the political resistance associated with
trying to alter the way in which an organization makes decisions and manages
its process— that is, trying to change its capabilities— bring on inertia. This
is not to say that companies cannot change. However, because change is so often
resisted by those who feel threatened by it, in most cases, change has to be
crisis induced.
Prior Strategic Commitments: Ghemawat has argued that a company’s
prior strategic commitments not only limit its ability to imitate rivals, but
may also cause competitive disadvantage. IBM, for instance, had made major
investments in the mainframe computer business. As a result, when the market
shifted, it was struck with significant resources that were specialized to that
particular business. The company had manufacturing facilities geared to the
production of mainframes, research organizations that were similarly
specialized, and a mainframe sales force. Since these resources were not well
suited to the newly emerging personal computer business, IBM’s current
difficulties were in a sense inevitable. Its prior strategic commitments locked
IBM into a business that was shrinking. Shedding these resources was bound to
cause hardship for all organization stakeholders.
The Icarus Paradox: In a recent book, Danny Miller proposed that the roots of
competitive failure can be found in what he termed the Icarus paradox. Icarus
is a figure in Greek mythology who made himself a pair of wings to escape from
an island where he was being held prisoner. He flew so well that he went higher
and higher, ever closer to the sun, until the hear of the sun melted the wax
that held his wings together and he plunged to his death in the Aegean Sea . The paradox is that his greatest asset, his
ability to fly, caused his demise. Miller argues that the same paradox applies
to many once successful companies. According to Miller, many companies become
so dazzled by their early success that they believe more of the same types of
effort is the way to future success. As a result, however, a company can become
so specialized and inner-directed that it loses sight of market realities and
the fundamental requirements for achieving a competitive advantage. Sooner or
later this leads to failure.
Miller identifies
four major categories among the rising and failing companies. The “craftsmen”,
such as Texas Instruments and Digital Equipment Corp. achieved early success
through engineering excellence. But then the companies became so obsessed with
engineering details that they lost sight of market realities. Then there are
the “builders”, for instance, Gulf & Western and ITT. Having built
successful, moderately diversified companies, they then became so enchanted
with diversification for its own sake that they continued to diversify far
beyond the point at which it was profitable to do so. Miller’s third group is
the “ pioneers” like Wang Labs. Enamored of their own originally brilliant
innovations, they continued to search for additional brilliant innovations, but
ended up producing novel but completely useless products. The final category
comprises the “salesman”, exemplified by Procter & Gamble. They became so
convinced of their ability to sell anything that they paid scant attention to
product development and manufacturing excellence and as a result spawned a
production of bland, inferior products.
Building Competitive Advantage Through Functional Level Strategies
The Value Chain The value a company creates is measured by the amount that buyers
are willing to pay for a product or service. A company is profitable if the
value it creates exceeds the cost of performing value-creation functions such
as manufacturing, and marketing. To gain a competitive advantage, a company
must either perform value-creation functions at a lower cost than its rivals or
perform them in a way that leads to differentiation and a premium price. That
is, it must pursue the strategies of low cost or differentiation.
Value chain consists
of those steps/functions that add value to the products without (sometimes)
distinguishing where they are being added. The value chain is divided between
primary activities and support activities (shown in the following Figure). Each
activity adds value to the product.
Figure:
The Value Chain
Primary activities have to go with the physical creation of the
product, its marketing and delivery to buyers, and its support and after-sales
service.
Support activities are the functional activities that allow the
primary activities of manufacturing and marketing to take place. The materials
management function controls the transmission of physical materials through the
value chain, from procurement through operations and into distribution. The efficiency
with which this is carried out can lower the cost of value creation. In
additions, an effective materials management function can monitor the quality
of inputs into the manufacturing process. This results in an increase in the
quality of a company’s outputs, thereby facilitating premium pricing. The
R&D function develops new product and process technologies. Technological
developments can lower manufacturing costs and result in the creation of more
attractive products that demand a premium price. Thus R&D can affect
primary manufacturing and marketing activities, and through them value
creation. The human resource function ensures that the company has the right
mix of skilled people to perform its value-creation activities effectively.
The final support activity is the company infrastructure, which
has a somewhat different character from the other support activities.
Infrastructure is the company-wide context within which all the other
value-creation activities take place; it includes the company’s organizational
structure, control systems, and culture. Since top management can exert
considerable influence in shaping these aspects of a company, top management
should also be viewed as part of the infrastructure. Top management, through
strong leadership, can consciously shape the infrastructure of a company, and
through that the performance of all other value-creation activities that take
place within it.
An important point to note is
that achieving the goals of superior efficiency, quality, innovation, and
customer responsiveness requires strategies that embrace several distinct
value-creation activities. Indeed, these goals can be regarded as goals that
cut across the different value-creation functions of a company. Attaining these
goals demands substantial cross-functional integration (Shown in the following
Figure).
Figure:
Cross-Functional Goals and the Value Chain Achieving Superior
Efficiency
A company can be viewed as a device for transforming inputs into
outputs. Inputs are basic factors of production such as labor, land, capital,
management, technological know-how, machinery, and so on. Outputs are the goods
and services that a company produces. Efficiency is measured by the cost of
inputs required to produce a given output. The more efficient a company, the
lower is the cost of inputs required to produce a given output. Put another
way, an efficient company has higher productivity than its rivals, and
therefore, lower costs. Here we review the various steps that companies can
take to boost their efficiency and, accordingly, lower their unit costs. Before
moving on, however, we must stress one key point: achieving superior quality
plays a major role in achieving superior efficiency.
Economies of Scale, Learning Effects, and the Experience Curve: One way of achieving
superior efficiency is by gaining economies of scale and learning effects. Both
of these concepts underlie a phenomenon referred to as the experience curve.
Before discussing the experience curve, we must consider economies of scale and
learning effects.
Economies of Scale: Economies of scale
are unit-cost reductions associated with a large scale of output. One source of
economies of scale is the ability to spread fixed costs over a large production
volume. Fixed costs are costs that must be incurred to produce a product
whatever the level of output; they include the costs of purchasing machinery,
the costs of setting up machinery for individual production runs, and the costs
of advertising and R&D. Spreading fixed costs over a large volume of output
lets a company reduce unit costs. Another source of scale economies is the
ability of companies producing in large volumes to achieve a greater division
of labor and specialization. Specialization, in turn, is said to have a
favorable impact on employee productivity, mainly because it enables
individuals to become very skilled at performing a particular task.
But these economies do not continue indefinitely. Indeed, most
experts agree that after a certain minimum efficient scale (MES) of output is
reached there are few, if any, additional scale economies to be had from
expanding volume. (Minimum efficient scale refers to the minimum plant size
necessary to gain significant economies of scale.) In other words, as shown in
the following Figure, the long-run unit cost curve of a company is L-shaped. At
outputs beyond MES in this Figure, additional cost reductions are hard to come
by.
Figure:
A
Figure:
A Typical Long-Run Unit-Cost Curve
Learning Effects: Learning effects are cost savings that come from learning by
doing. Labor, for example, learns by repetition how best to carry out a task.
In other words, labor productivity increases over time, and unit costs fall as
individuals learn the most efficient way to perform a particular task. Equally
important, in new manufacturing facilities management typically learns how best
to run the new operation. Hence, production costs decline because of'
increasing labor productivity and management efficiency.
Learning effects tend to be more significant in situations where a
technologically complex task is repeated, since there is more to learn. Thus
learning effects will be more significant in an assembly process involving
1,000 complex steps than in an assembly process involving 100 simple steps. No
matter how complex the task, however, learning effects typically die out after
a limited period of time. Indeed, it has been suggested that they are really
important only during the start-up period of a new process and cease after two
or three years.
The Experience Curve:
The
experience curve refers to systematic unit-cost reductions that have been
observed to occur over the life of a product. According to the experience curve
concept, unit manufacturing costs for a product typically decline by some characteristic
amount each time accumulated output of the product is doubled (accumulated
output is the total output of a product since its introduction). There is a
relationship between unit manufacturing costs and accumulated output (Shown in
the following Figure).
Figure: A
Typical Experience Curve
Economies of scale and learning effects underlie the experience
curve phenomenon. Put simple, as a company increases the accumulated volume of
its output over time, it is able to realize both economies of scale (as volume
increases) and learning effects. Consequently, unit costs fall with increases
in accumulated output.
The strategic significance of the experience curve is clear. It
suggests that increasing a company’s product volume and market share will also
bring cost advantages over the competition. Thus company A in the above Figure,
because it is further down the experience curve, has a clear cost advantage,
over company B.
The concept is perhaps most important in those industries where
the production process involves the mass production of a standardized output
(for example, the manufacture of semiconductor chips). If a company wishes to
become more efficient, and thereby attain a low-cost position, it must try to
ride down the experience curve as quickly as possible. This involves
constructing efficient scale manufacturing facilities even before the company
has the demand, and the aggressive pursuit of cost reductions from learning
effects. The company might also need to pursue an aggressive marketing strategy,
cutting prices to the bone and stressing heavy sales promotions in order to
build up demand, and hence accumulated volume, as quickly as possible. Once
down the experience curve, because of its superior efficiency, the company is
likely to have a significant cost advantage over its competitors.
However, the company furthest down the experience curve must not
become complacent about its cost advantage. More generally, there are three
reasons why companies should not become complacent about their efficiency-based
cost advantages derived from experience effects. First, since neither learning
effects nor economies of scale go on forever, the experience curve is likely to
bottom out at some point; indeed, it must do so by definition. When this occurs,
further unit-cost reductions from learning effects and economies of scale will
be hard to come by. Thus, in time, other companies can catch up with the cost
leader. Once this happens, a number of low-cost companies can have cost parity
with each other. In such circumstances, establishing a sustainable competitive
advantage must involve other strategic factors besides the minimization of
production costs by utilizing existing technologies— factors such as better
customer responsiveness, product quality, or innovation.
Second, cost advantages gained from experience curve effects can
be made obsolete by the development of new technologies. Technological change
can alter the rules of the game, requiring that former low-cost companies take
steps to reestablish their competitive edge.
A further reason for
avoiding complacency is that high volume does not necessarily give a company a
cost advantage. Some technologies have different cost functions. For example,
the steel industry has two alternative manufacturing technologies: an
integrated technology, which relies on the basic oxygen furnace, and a minimill
technology, which depends on electric arc furnace. As illustrated in the
following Figure, the minimum efficient scale (MES) of the electric arc furnace
is located at relatively low volumes, whereas the MES of the basic oxygen
furnace is located at relatively high volumes. Even when both operations are
producing at their most efficient output levels, steel companies with basic
oxygen furnaces do not have a cost advantage over minimills.
Figure: Unit
Production Costs in an Integrated Steel Mill and a Minimill
Consequently, the pursuit of experience economies by an integrated
company using basic oxygen technology may not bring the kind of cost advantages
that a naive reading of the experience curve phenomenon would lead the company
to expect. Indeed, in recent years integrated companies have not been able to
get enough orders to run at optimum capacity. Hence their production costs have
been considerably higher than those of minimills. More generally, in many
industries new flexible manufacturing technologies hold out the promise of
allowing small manufacturers to produce at unit costs comparable to those of
large assembly-line operations.
Flexible
Manufacturing (Lean Production) and Efficiency: Central to the
concept of economies of scale is the idea that the best way to achieve high
efficiency, and hence low unit costs, is through the mass production of a
standardized output. The tradeoff implicit in this idea is one between costs
and product variety. Producing greater product variety form a factory implies
shorter production runs, which in turn implies an inability to realize
economies of scale. That is, increasing product variety makes it difficult for
a company to increase its manufacturing efficiency and thus reduce its unit
costs. According to this logic, the way to increase efficiency and drive down
unit costs is to limit product variety and produce a standardized product in
large volumes (see the following Figure-a).
Figure:
The Tradeoff Between Costs and Product Variety
This view of manufacturing efficiency has been challenged by the
rise of flexible manufacturing technologies. The term flexible manufacturing
technology— or lean production, as this technology is often called— covers a
range of manufacturing technologies designed to (1) reduce setup times for
complex equipment, (2) increase the utilization of individual machines through
better scheduling, and (3) improve quality control at all stages of the
manufacturing process. Flexible manufacturing technologies allow the company to
produce a wider variety of end products at a unit cost that at one time could
only be achieved through the mass production of a standardized output (see the
above Figure-b). Indeed, recent research suggests that the adoption of flexible
manufacturing technologies may actually increase efficiency and lower unit
costs relative to what can be achieved by the mass production of a standardized
output. Flexible manufacturing technologies vary in their sophistication and
complexity.
Flexible machine cells are one common flexible manufacturing
technology. A flexible machine cell is a grouping of various types of
machinery, a common materials handler, and a centralized cell controller
(computer). Each cell normally contains four to six machines capable of
performing a variety of operations. The typical cell is dedicated to the
production of a family of parts or products. The settings on machines are
computer controlled. This allows each cell to switch quickly between the
production of different parts or products. Improved capacity utilization and
reductions in work-in-progress (that is, stockpiles of partly finished
products) and waste are major efficiency benefits of flexible machine cells.
Besides, improving efficiency and lowering costs, flexible
manufacturing technologies let companies customize products to the unique
demands of small consumer groups—at a cost that at one time could only be
achieved by mass producing a standardized output. Thus they help a company
increase its customer responsiveness.
Marketing Strategy and Efficiency: Marketing strategy—
the position that a company takes with regard to pricing, promotion,
advertising, product design, and distribution— can play a major role in
boosting a company’s efficiency. Some of the steps leading to greater
efficiency are fairly obvious. For example, we have already discussed how
riding down the experience curve to gain a low-cost position can be facilitated
by aggressive pricing, promotions, and advertising— all of which are the task
of the marketing function. However, there are other aspects of marketing
strategy that have a less obvious but no less important impact on efficiency.
Perhaps the most important is the relationship between customer defection rates
and unit costs.
Customer defection
rates are the percentage of a company’s customers that defect every year to
competitors. Defection rates are determined by customer loyalty, which in turn
is a function of the ability of a company to satisfy its customers. Because
acquiring a new customer entails certain one-time fixed costs for advertising,
promotions, and the like, there is a direct relationship between defection
rates and costs. The longer a company holds on to a customer, the greater is
the volume of customer-generated unit sales that can be set against these fixed
costs, and the lower the average unit cost of each sale. Thus lowering customer
defection rates allows a company to achieve substantial cost economies. This is
illustrated in the following Figure, which shows that high defection rates
imply high average unit costs (and vice-versa).
Figure:
The Relationship Between Average Unit Costs and Customer Defection Rates
One consequence of
the relationship summarized in the above Figure is a relationship, illustrated
in the following Figure, between the length of time that a customer stays with
the company and profit per customer. Because of the fixed costs of acquiring
new customers, serving customers that stay with the company only for a short
time before switching to competitors can often yield a negative profit.
However, the longer a customer stays with the company, the more the fixed costs
of acquiring that customer can be spread out over repeat purchases, which
boosts the profit per customer. Thus, as shown in the following Figure, there
is a positive relationship between the length of time that a customer stays
with a company and profit per customer
Figure:
The Relationship Between Customer Loyalty and Profit Per Customer
The key message is that reducing customer defection rates and
building customer loyalty can be a major source of cost saving. Because it
leads to lower unit costs, reducing customer defection rates by just 5 percent
can increase profits per customer anywhere from 25 percent to 85 percent
depending on the industry. A company reduces customer defection rates by
building brand loyalty, which in turn requires that the company be responsive
to the needs of its customers.
Materials Management Strategy, JIT and Efficiency: The contribution of
materials management to boosting the efficiency of a company can be just as
dramatic as the contribution of manufacturing and marketing. Materials
management encompasses the activities necessary to get materials to a
production facility, through the production process, and out through a
distribution system to the end user. The potential for reducing costs through
more efficient materials management is enormous. Even a small reduction in
material management costs can have substantial impact on profitability. In a
saturated market, it would be much easier to reduce materials costs.
Improving the efficiency of the materials management function
typically requires the adoption of just-in-time (JIT) inventory systems. The
basic philosophy behind JIT is to economize on inventory holding costs by
having materials arrive at a manufacturing plant just in time to enter the
production process and not before. The major cost saving comes from increasing
inventory turnover, which reduces inventory holding costs, such as warehousing
and storage costs.
The drawback of JIT systems is that they leave a firm without a
buffer stock of inventory. Although buffer stocks of inventory are expensive to
store, they can help tide a firm over shortages on inputs brought about by
disruption among suppliers (for instance. a labor dispute at a key supplier).
Buffer stocks can also help a firm respond quickly to increases in demand.
R&D Strategy and Efficiency: The role of superior
research and development in helping a company achieve greater efficiency is
twofold. First, the R&D function can boost efficiency by designing products
that are easy to manufacture. By cutting down on the number of parts that make
up a product, R&D can dramatically decrease the required assembly time,
which translates into higher employee productivity and lower unit costs.
The second way in which the R&D function can help a company to
achieve greater efficiency is by pioneering process innovations. A process innovation
is an innovation in the way production processes operate that improves the
efficiency of those processes. Process innovations have often been a major
source of competitive advantage.
Human Resources Strategy and Efficiency: Employee productivity
is one of the key determinants of an enterprise’s efficiency and cost
structure. The more productive the employees, the lower will be the unit costs.
The challenge for a company’s human resource function is to devise ways to
increase employee productivity. It has three main choices: training employees;
organizing the work force into self-managing teams; and linking pay to
performance.
Employee Training: Individuals are a major input into the production process. A
company that employs individuals with higher skills is likely to be more
efficient than one employing less skilled personnel. Individuals who are more
skilled can perform tasks faster and more accurately and are more likely to
learn the complex tasks associated with many modem production methods than
individuals with lesser skills. Training can upgrade employee skill levels,
bringing the firm productivity-related efficiency gains.
Training programs have four main components. First, rotating
employees through various departments lets them acquire general skills. Second,
companies may use extensive off-the-job training. Third, many companies
encourage their employees to develop skills through correspondence courses,
whose costs the employers often reimburse on completion of the program.
Finally, participation in team activities focused on improving company
performance results in a general upgrading of employee skill levels.
Self-Managing Teams: Self-managing teams are a relatively recent phenomenon. The growth
of flexible manufacturing cells, which group workers into teams, has
undoubtedly facilitated the spread of self-managing teams. The typical team
comprises five to fifteen employees who produce an entire product or
subassembly. Team members learn all team tasks and rotate from job to job. A
more flexible work force is one result. Team members can fill in for absent
coworkers. Teams also take over managerial duties such as work and vacation
scheduling, ordering materials, and hiring new members. The greater
responsibility thrust on team members and the empowerment it implies are seen
as motivators. (Empowerment is the process of giving lower-level employees
decision-making power.) People often respond well to being given greater
autonomy and responsibility. Performance bonuses linked to team production and
quality targets work as an additional motivator.
Pay for
Performance: People work for money, so it is hardly surprising
that linking pay to performance can help increase employee productivity.
However, the issue is not quite as simple as just introducing incentive pay
systems; it is also important to define what kind of performance is to be
rewarded and how. Some of the most
efficient
companies in the world, mindful that cooperation among employees is necessary
to realize productivity gains, do not link pay to individual performance.
Instead they link pay to group or team performance. Bonus pay is linked to the
ability of the team to meet productivity and quality goals. This creates a
strong incentive for individuals to cooperate with each other in pursuit of
team goals; that is, it facilitates teamwork.
Infrastructure and Efficiency: The infrastructure sets the context
within which all other value-creation activities take place. It follows that
the infrastructure can help in achieving efficiency goals. Above all, the
infrastructure can foster a company-wide commitment to efficiency and promote
cooperation among different functions in pursuit of efficiency goals.
A company-wide commitment to efficiency can be built through top
management leadership. The leadership task is to articulate a vision that
recognizes the need for all functions of the company to focus on improving
their efficiency. It is not enough just to improve the efficiency of
manufacturing, or marketing, or R&D. Achieving superior efficiency requires
a company-wide commitment to this goal, and this can be articulated only by top
management. A further leadership task is to facilitate cross-functional
cooperation needed to achieve superior efficiency. Achieving
Superior Quality
Achieving superior quality gives a company two advantages. The
enhanced reputation for quality lets the company charge a premium price for its
product, and the elimination of defects from the manufacturing process
increases efficiency and hence lowers costs.
The main concept utilized to enhance quality is total quality
management (TQM). TQM is a management philosophy that focuses on improving the
quality of a company’s products and services and stresses that all company
operations should be oriented toward this goal. A company-wide philosophy, it
requires the cooperation of all the different functions if it is to be
successfully implemented.
The TQM Concept: The total quality management (TQM) concept was first developed by
a number of American consultants, including W. Edwards Deming, Joseph Juran,
and A. V. Feigenbaum. The philosophy underlying TQM, as articulated by Deming,
is based on the following five-step “chain reaction”:
1.
Improved quality means that costs decrease because of less rework,
fewer mistakes, fewer delays, and better use of rime and materials.
2.
As a result, productivity improves.
3.
Better quality leads to higher market share and allows the company
to rise prices.
4.
This increases the company’s profitability and allows it to stay
in business.
5.
Thus the company creates more jobs.
Achieving
Superior Innovation
In many ways innovation is the single most important building
block of competitive advantage. Successful innovation of products or processes
gives a company something unique that its competitors lack. This uniqueness may
allow a company to charge a premium price or lower its costs structure below
that of its rivals. Competitors, however, will try to imitate successful
innovations. Often they will ultimately succeed, although high barriers to
imitation can slow it down. Therefore, maintaining a competitive advantage
requires a continuing commitment to innovation. Achieving
Superior Customer Responsiveness
Achieving superior
customer responsiveness involves giving customers value for money, and steps taken
to improve the efficiency of a company’s production process and the quality of
its output should be consistent with this aim. In addition, giving customers
what they want may require the development of new products that have features
not incorporated in existing ones. In other words, achieving superior
efficiency, quality, and innovation are all part of achieving superior customer
responsiveness. There are two other prerequisites for attaining this goal. The
first is to focus on the company’s customers and their needs, and the second,
to find ways to better satisfy those needs.
Business
Level Strategy
Foundations of Business-Level Strategy We discuss Derek F.
Abell’s view of the process of business definition as involving decisions about
(1) customer needs, or what is to be satisfied, (2) customer groups, or who is
to be satisfied, and (3) distinctive competencies, or how customer needs are to
be satisfied. These three decisions are at the heart of business-level strategy
choice because they provide the source of a company’s competitive advantage
over its rivals and determine how the company will compete in a business or
industry. Consequently, we need to look at the ways in which companies can gain
a competitive advantage at the business level.
Customer Needs and Product Differentiation: Customer needs are
anything that can be satisfied by means of the characteristics of a product or
service. Product differentiation is the process of creating a competitive
advantage by designing products— goods and services— to satisfy customer needs.
All companies must differentiate their products to a certain degree in order to
attract customers and satisfy some minimal level of customer needs.
Some companies offer the customer a low-priced product without
engaging in much product differentiation. Others seek to create something
unique about their products so that they satisfy customer needs in ways that
other products cannot. The uniqueness may relate to the physical
characteristics of the product, such as quality or reliability, or it may lie
in the product's appeal to customers’ psychological need, such as the need for
prestige or status.
Customer Groups and Market Segmentation: Market segmentation
may be defined as the way a company decides to group customers, based on
important differences in their needs or preferences, in order to gain a
competitive advantage. In general, a company can adopt three alternative
strategies toward market segmentation. First, it may choose not to recognize
that different groups of customers have different needs and may adopt the
approach of serving the average customer. Second, a company may choose to
segment its market into different constituencies and develop a product to suit
the needs of each group. Third, a company can choose to recognize that the
market is segmented but concentrate on servicing only one market segment, or
niche.
A company wants to make complex product/market choices and creates
a different product tailored to each market segment rather than create a single
product for the whole market. Because the decision to provide many products for
many market niches allows a company to satisfy customer needs better. As a
result, customer demand for the company’s products rises and generates more
revenue than would be the case if the company offered just one product for the
whole market. Instead, price is the main criterion used by customers to
evaluate the product, and the competitive advantage lies with the company that
has superior efficiency and can provide the lowest-priced product.
Deciding on Distinctive Competencies: The third issue in
business-level strategy is to decide what distinctive competencies to pursue to
satisfy customer needs and groups. In this context, distinctive competencies
are the means by which a company attempts to satisfy customer needs and groups
in order to obtain a competitive advantage. There are four ways in which
companies can obtain a competitive advantage: through achieving superior
efficiency, quality, innovation, and customer responsiveness. In making
business strategy choices, a company must decide how to organize and combine
its distinctive competencies to gain a competitive advantage.
Choosing
a Generic Competitive Strategy at the Business Level Companies pursue a
business-level strategy to gain a competitive advantage that allows them to
outperform rivals and achieve above-average returns. They can choose from
three generic competitive approaches: cost leadership, differentiation, and
focus. These strategies are called generic because all business or industries
can pursue them regardless of whether they are manufacturing, service, or
not-for-profit enterprises. Each of the generic strategies results from a
company making consistent choices on product, market, and distinctive
competencies-choices that reinforce each other. The following Table
summarizes the choices appropriate for each generic strategy.
Product/Market/Distinctive-Competency
Choices and Generic Competitive Strategies
|
|||||
Cost
Leadership
|
Differentiation
|
Focus
|
|||
Product
differentiation
|
Low
(principally by price)
|
High
(principally by uniqueness)
|
Low
to high
(price
or uniqueness)
|
||
Market
segmentation
|
Low
(mass market)
|
High
(many market segments)
|
Low
(one or a few segments)
|
||
Distinctive
competency
|
Manufacturing
and materials management
|
Research
and development, sales and marketing
|
Any
kind of distinctive competency
|
||
Advantages and Disadvantages: The cost leader is protected from
industry competitors by its cost advantage. Its lower costs also mean that it
will be less affected than its competitors by increases in the price of inputs
if there are powerful suppliers and less affected by a fall in the price it can
charge for its products if there are powerful buyers. Moreover, since cost
leadership usually requires a big market share, the cost leader purchases in
relatively large quantities, increasing bargaining power vis-a-vis suppliers.
If substitute products start to come into the market, the cost leader can
reduce its price to compete with them and retain its market share. Finally, the
leader's cost advantage constitutes a barrier to entry, since other companies
are unable to enter the industry and match the leader's costs or prices. The
cost leader is therefore relatively safe as long as it can maintain its cost advantage-and
price is the key for a significant number of buyers.
The principal dangers of the cost-leadership approach lurk in
competitors ability to find ways of producing at lower cost and beat the cost
leader at its own game. Finally, the cost-leadership strategy carries a risk
that the cost leader, in the single minded desire to reduce costs, may lose
sight of changes in customer tastes. Thus a company might make decisions that
decrease costs but drastically affect demand for the product.
Differentiation Strategy: The objective of the generic strategy of
differentiation is to achieve a competitive advantage by creating a
product—good or service—that is perceived by customers to be unique in some
important way. The differentiated company’s ability to satisfy a customer need
in a way that its competitors cannot means that it can charge a premium price—a
price considerably above the industry average. The ability to increase revenues
by charging premium prices (rather than by reducing costs like the cost leader)
allows the differentiator to outperform its competitors and gain above-average
profits. The premium price is usually substantially above the price charged by
the cost leader, and customers pay it because they believe the product's
differentiated qualities to be worth the difference. Consequently, the product
is priced on the basis of what the market will bear.
Strategic Choices: A differentiator chooses a high level of product differentiation
to gain a competitive advantage. Product differentiation can be achieved in
three principal ways; qualities, innovation, and customer responsiveness.
Innovation is very important for technologically complex products, where new
features are the source of differentiation, and many people pay a premium price
for new and innovative products, such as a state-of-the-art computer, stereo,
or car. When differentiation is based on customer responsiveness, a company
offers comprehensive after-sales service and product repair. This is an
especially important consideration for complex products such as cars and
domestic appliances, which are likely to break down periodically.
Finally a product's appeal to customers’ psychological desires can
become a source of differentiation. The appeal can be to prestige or status, as
it is with BMWs and Rolex watches; to patriotism, as with buying a Chevrolet to
safety of home and family, as with Prudential Insurance; or to value for money,
as with Sears and JC Penny. Differentiation can also be tailored to age groups
and socioeconomic groups. Indeed, the bases of differentiation are endless. A
company that pursues a differentiation strategy strives differentiate itself
along as many dimensions as possible. The less it resembles its rivals, the
more it is protected from competition and the wider is its market appeal.
Generally, a differentiator chooses to segment its market into
many niches. Now and then a company offers a product designed for each market
niche and decides to be a broad differentiator, but a company might choose to
serve just those niches where it has a specific differentiation advantage. For
example, Sony produces twenty four models of television, filling all the niches
from midpriced to high-priced sets.
Finally, in choosing which distinctive competency to pursue, a
differentiated company concentrates on the organizational function that
provides the sources of its differentiation advantage. Differentiation on the
basis of innovation and technological competency depends on the R&D
function. Efforts to improve customer service depend on the quality of the
sales function. A focus on a specific function does not mean, however, that the
control of costs is not important for a differentiator. A differentiator does
not want to increase costs unnecessarily and tries to keep them somewhere near
those of the cost leader. But, since developing the distinctive competency
needed to provide a differentiation advantage is often expensive, a
differentiator usually has higher costs than the cost leader. Still, it must
control all costs that do not contribute to its differentiation advantage so
that the price of the product does not exceed what customers are willing to
pay. Since bigger profits are earned by controlling costs, as well as by
maximizing revenues, it pays to control costs, though not to minimize them to
the point of losing the source of differentiation.
Both Cost Leadership and Differentiation: Recently, changes in
production techniques— in particular, the development of flexible manufacturing
technologies— have made the choice between cost-leadership and differentiation
strategies less clear-cut. Because of technological developments, companies
have found it easier to obtain the benefits of both strategies. The reason is
that the new flexible technologies allow firms to pursue a differentiation
strategy at a low cost.
Traditionally, differentiation was obtainable only at high cost
because the necessity of producing different models for different market
segments meant that firms had to have short production runs, which raised manufacturing
costs. In addition, the differentiated firm had to bear higher marketing costs
than the cost leader because it was servicing many market segments. As a
result, differentiators had higher costs than cost leaders that produced large
batches of standardized products. However, flexible manufacturing may enable a
firm pursuing differentiation to manufacture a range of products at a cost
comparable to that of the cost leader. The use of robots and flexible
manufacturing cells reduces the costs of retooling the production line and the
costs associated with small production runs.
A firm can also reduce both production and marketing costs if it
limits the number of models in the product line by offering packages of options
rather than letting consumers decide exactly what options they require.
Just-in-time inventory systems can also help reduce costs and
improve the quality and reliability of a company's products. This is important
to differentiated firms, where quality and reliability are essential ingredients
of the product's appeal.
Focus Strategy: The third pure generic competitive strategy, the focus strategy,
differs from the other two chiefly because it is directed towards serving the
needs of a limited customer group or segment. A focused company concentrates on
serving a particular market niche, which may be defined geographically, by type
of customer, or by segment of the product line. For example, a geographical
niche may be defined by region or even by locality. Selecting a niche by type
of customer might mean serving only the very rich or the very young or the very
adventurous. Concentrating only on a segment of the product line means focusing
only on vegetarian foods or on very fast motor cars or on designer clothes. In
following a focus strategy, a company is specializing in some way.
Once it has chosen its market segment, a company may pursue a
focus strategy through either a differentiation or a low-cost approach. In
essence, a focused company is a specialized differentiator or cost leader. Because
of their small size few focus firms are able to pursue cost leadership and
differentiation simultaneously. If a focus firm uses a low-cost approach, it
competes against the cost leader in the market segments where it has no cost
disadvantage. For example, in local lumber or cement markets, the focuser has
lower transportation costs than the low-cost national company. The focuser may
also have a cost advantage because it is producing complex or custom-built
products that do, not lend themselves easily to economies of scale in
production and therefore offer few experience-curve advantages. With a focus
strategy, a company concentrates on small-volume custom products, where it has
a cost advantage, and leaves the large-volume standardized market to the cost
leader.
If a focuser pursues a differentiation approach, then all the
means of differentiation that are open to the differentiator are available to
the focused company. The point is that the focused company competes with the
differentiator in only one or in just a few segments. For example, Porsche, a
focused company, competes against General Motors in the sports car segment of
the car market but not in the other segments. Focused companies are likely to
develop differentiated product qualities successfully because of their
knowledge of a small customer set (such as sports car buyer) or knowledge of a
region. Furthermore, concentration on a small range of products sometimes
allows a focuser to develop innovations faster than a large differentiator can.
However, the focuser does not attempt to serve all market segments because
doing so would bring it into direct competition with the differentiator.
Instead, a focused company concentrates on building market share in one market
segment and, if successful, may begin to serve more and more market segments
and chip away at the differentiator's competitive advantage.
Being Stuck in the Middle: Each generic strategy requires a company
to make consistent product/market/distinctive-competency choices to establish a
competitive advantage. In other words, a company must achieve a fit among the
three components of business level strategy. Thus, for example, a low-cost
company cannot go for a high level of market segmentation, like a
differentiator, and provide a wide range of products because doing so would
raise production costs too much and the company would lose its low-cost
advantage. Similarly, a differentiator with a competency in innovation that
tries to reduce in expenditures on research and development or one with a
competency in customer responsiveness through after-sales service that seeks to
economize on its sales force to decrease costs is asking for trouble because it
will lose its competitive advantage as its distinctive competency disappears.
Some stuck-in-the-middle companies started out pursuing one of the
three generic strategies but made wrong decisions or were subject to
environmental changes. Losing control of a generic strategy is very easy unless
management keeps close track of the business and its environment, constantly
adjusting product/market choices to suit changing industry conditions. A
focuser can get stuck in the middle when it becomes overconfident and starts to
acts like a broad differentiator.
To sum up, successful management of a generic competitive strategy
requires strategic managers to attend to two main matters. First, they need to
ensure that the product/market/distinctive-competency decisions they make are
oriented toward one specific competitive strategy. Second, they need to monitor
the environment so that they can keep the firm's sources of competitive
advantage in tune with changing opportunities and threats.
Choosing an Investment Strategy at the Business Level
An investment strategy refers to the amount and type of resources—both
human and financial—that must be invested to gain a competitive advantage.
Generic competitive strategies provide competitive advantages, but they are
expensive to develop and maintain. Differentiation is the most expensive of
three because it requires that a company invest resources in many functions,
such as research and development and sales and marketing, to develop
&distinctive competencies. Cost leadership is less expensive to maintain
once the trial investment in a manufacturing plant and equipment has been made.
It does not require such sophisticated research and development or marketing
efforts. The focus strategy is cheapest because fewer resources are needed to
serve one market segment than to serve the whole market
In deciding on an investment strategy, a company must evaluate the
potential returns from investing in a generic competitive strategy against the
cost of developing the strategy. In this way, it can determine whether a
strategy is likely to be profitable to pursue and how profitability will change
as industry competition changes. Two factors are crucial in choosing an
investment strategy: the strength of a company's position in an industry
relative to its competitors and the stage of the industry life cycle in which
the company is competing.
Competitive Position: Two attributes can be used to determine the strength of a
company's relative competitive position. First, the larger a company's market
share, the stronger is its competitive position and the greater are the
potential returns from future investment. This is because a large market share
provides experience-curve economies and suggests that the company has developed
brand loyalty. The strength and uniqueness of a company's distinctive
competencies are the second measure of competitive position. If it is difficult
to imitate a company's research and development expertise, its manufacturing or
marketing skills, its knowledge of particular customer segments, or its unique
reputation or brand name, the company's relative competitive position is strong
and its returns from the generic strategy increase. In general, the companies
with the largest market share and strongest distinctive competencies are in the
best position.
These two attributes obvious reinforce one another and explain why
some companies get stronger and stronger over time. A unique competency leads
to increased demand f or the company's products, and then, as a result of
larger market share, the company has more resources to investing developing its
distinctive competency. Companies with a smaller market share and little
potential for developing a distinctive competency are in a weaker competitive
position. Thus they are less attractive sources for investment.
Life Cycle Effect: The second main factor influencing the investment attractiveness
of a generic strategy is the stage of the industry life cycle. Each life cycle
stage is accompanied by a particular industry environment, presenting different
opportunities and threats. Each stage, therefore, has different implications
for the investment of resources needed to obtain a competitive advantage. For
example, competition is strongest in the shakeout stage of the life cycle and
least important in the embryonic stage, so the risks of pursuing a strategy
change over time. The difference in risk explains why the potential returns
from investing in a competitive strategy depend on the life cycle stage.
Choosing and
Investment Strategy:
The following Table summarizes the relationship among the stage
of the life cycle, competitive position, and investment strategy at the
business level.
Choosing
An Investment Strategy at the Business Level
|
|||
Strong
competitive position
|
Weak
competitive position
|
||
Stage
of industry life cycle
|
|||
Embryonic
|
Share
building
|
Share
building
|
|
Growth
|
Growth
|
Market
concentration
|
|
Shakeout
|
Share
increasing
|
Market
concentration or harvest/liquidation
|
|
Maturity
|
Hold
-and-maintain or profit
|
Harvest
or liquidation/divesture
|
|
Decline
|
Market
concentration, harvest, or asset reduction
|
Turnaround,
liquidation, or divesture
|
|
Embryonic Strategy: In the embryonic stage, all companies, weak and strong, emphasize
the development of a distinctive competency and a product/market policy. During
this stage, investment needs are great because a company has to establish a
competitive advantage. Many fledgling companies in the industry are seeking
resources to develop a distinctive competency. Thus the appropriate
business-level investment strategy is a share-building strategy. The aim is to
build market share by developing a stable and unique competitive advantage to
attract customers who have no knowledge of the company's products.
Companies require large amounts of capital to build research and
&development competencies or sales and service competencies. They cannot
generate much of this capital internally. Thus a company's success depends on
its ability to demonstrate a unique competency to attract outside investors, or
venture capitalists. If a company gains the resources to develop a distinctive
competency, it will be in a relatively stronger competitive position. If it
falls, its only option may be to exit the industry. In fact, companies in weak
competitive positions at all stages in the life cycle may choose to exit the
industry to cut their losses.
Growth Strategies: At the growth stage, the task facing a company is to consolidate
its position and provide the base it needs to survive the coming shakeout. Thus
the appropriate investment strategy is the growth strategy. The goal is to
maintain a company's relative competitive position in a rapidly expanding
market and, if possible, to increase it-in other words, to grow with the
expanding market. However, other companies are entering the market and catching
up with the industry innovators. As a result, companies require successive
waves of capital infusion to maintain the momentum generated by their success
in the embryonic stage. For example, differentiators are engaging in massive
research and development, and cost leaders are investing in plant to obtain
experience-curve economies. All this investment is very expensive.
Companies in a weak competitive position at this stage engage in a
market concentration strategy to consolidate their position. They seek to
specialize in some way and adopt a focus strategy to reduce their investment
needs. If very weak, they may also choose to exit the industry.
Shakeout Strategies: By the shakeout stage, demand is increasing slowly and competition
by price or product characteristics has become intense. Thus companies in
strong competitive positions need resources to invest in a share increasing
strategy to attract customers from weak companies that are exiting the market.
In other words, companies attempt to maintain and increase market share despite
fierce competition. The way companies invest their resources depends on their
generic strategy. Weak companies exiting the industry engage in a harvest or
liquidation strategy.
Maturity Strategies: By the maturity stage, a strategic group structure has emerged in
the industry, and companies have learned how their competitors will react to
their competitive moves. At this point companies want to reap the rewards of
their previous investments in developing a generic strategy. As market growth
slows in the maturity stage, a company’s investment strategy depends on the
level of competition in the industry and the source of the company’s
competitive advantage.
In environments where competition is high because technological
changes is occurring or where barriers to entry are low, companies need to
defend their competitive position. Strategic managers need to continue to
invest heavily in maintaining the company’s competitive advantage. Both
low-cost companies and differentiators adopt a hold-and-maintain strategy to
support their generic strategies. They expend resources to develop their
distinctive competency so as to remain the market leaders.
Decline Strategies: The initial strategies that companies can adopt in decline stage
are market concentration and asset reduction. With a market concentration
strategy, a company attempts to consolidate its product and market choices. It
narrows its product range and exits marginal niches in an attempt to redeploy
its investments more efficiently and improve its competitive position. Reducing
customer needs and the customer groups served may allow the company to pursue a
focus strategy in order to survive the decline stage.
An asset reduction strategy requires a company to limit or
decrease its investment in a business and to extract, or milk, the investment
as much as it can. This approach is sometimes called a harvest strategy because
the company reduces to a minimum the assets it employs in the business and
forgoes investment for the sake of immediate profits. A market concentration
strategy generally indicates that a company is trying to turn around its
business so that it can survive in the long run. A harvest strategy implies
that a company will exit the industry once it has harvested all the returns it
can. At any stage of the life cycle, companies that are in weak competitive
positions may apply turnaround strategies.
If a company decides that turnaround is not possible, either for
competitive or for life cycle reasons, then the two remaining investment
alternatives are liquidation and divestiture. As the terms imply, the company
moves to exit the industry either by liquidating its assets or by selling the
whole business. Both can be regarded as radical forms of harvesting strategy
because the company is seeking to get back as much as it can from its
investment in the business.
Business Level Strategy and the Industry Environment Strategy
in Fragmented Industries A fragmented industry is one composed of a large number of small
and medium sized companies. There are several reasons why an industry may
consist of many small companies rather than a few large ones. In some
industries there are few scale economies, and so large companies do not have an
advantage over smaller enterprises. Indeed, in some industries there are
diseconomies of scale. Many home-buyers, for example, have a preference for
dealing with local real estate agents, whom they perceive as having better
local knowledge than national chains. Similarly, in the restaurant business,
many individuals have an aversion to national chains and prefer the unique
style-of a local restaurant. In addition, because of the lack of scale
economies, many fragmented industries are characterized by low barriers to
entry and new entry keeps the industry fragmented. The video rental industry
exemplifies this situation: the costs of opening up a video rental store are
very moderate and can be borne by a single entrepreneur. High transportation
costs, too, can keep an industry fragmented, for regional production may be the
only efficient way to satisfy customer needs, as in the cement business.
Finally, an industry may be fragmented because customer needs are so
specialized that only small job lots of products are required, and thus there
is no room for a large mass production operation to satisfy the market.
To grow, consolidate their industries, and become the industry
leaders, they are utilizing three main strategies: (1) chaining, (2)
franchising, and (3) horizontal merger.
Chaining: Companies like Wal-Mart Stores and Midas International Corporation
are pursuing a chaining strategy in order to obtain the advantages of a
cost-leadership strategy. They establish networks of linked merchandising
outlets that are so interconnected that they function as one large business
entity. The amazing buying power that these companies possess through their
nationwide store chains allows them to negotiate large price reductions with
their suppliers and promotes their competitive advantage. They overcome the
barrier of high transportation costs by establishing sophisticated regional
distribution centers, which can economize on inventory costs and maximize
responsiveness to the needs of stores and customers (this is Wal-Mart’s
specialty). Last but not least, they realize economies of scale from sharing
managerial skills across the chain and from nationwide, rather than local,
advertising.
Franchising: For differential companies in fragmented industries, such as
McDonald’s or Century 21 Real Estate Corporation, the competitive advantage
comes from the business strategy of franchising. With franchising, a local
store operation is both owned and managed by the same person. When the owner is
also the manager, he or she is strongly motivated to control the business
closely and make sure the quality and standards are consistently high so that
customer needs are always satisfied. Such motivation is particularly critical
in a strategy of differentiation, where it is important for a company to
maintain its uniqueness. One reason that industries fragment is the difficulty
of maintaining control over, and the uniqueness of, the many small outlets that
must be operated. Franchising avoids this problem. In addition, franchising
lessens the financial burden of swift expansion, and so permits rapid growth of
the company. Finally, a differentiator can reap the advantages of large-scale
advertising, as well as the purchasing, managerial, and distribution economies
of a large company, as McDonald's does very efficiently. Indeed, McDonald's is
able to pursue cost leadership and differentiation simultaneously only because
franchising allows costs to be controlled locally and differentiation can be
achieved by marketing on a national level.
Horizontal Merger: Companies like Dillard's and Blockbuster Entertainment have been
choosing a business-level strategy of horizontal merger to consolidate their
respective industries. Such companies have arranged mergers of small companies
in an industry in order to create a few large companies. For example, Dillard's
arranged the merger of regional store chains in order to form a national
company. By pursuing horizontal merger, companies are able to obtain economies
of scale or secure a national market for their product. As a result, they are
able to pursue a cost-leadership or a differentiation strategy.
The challenge in a fragmented industry is to choose the most
appropriate means-franchising, chaining, or horizontal merger-of overcoming a
fragmented market so that the advantages of the generic strategy can be
realized. It is difficult to think of any major service activities from
consulting and accounting firms to businesses satisfying the smallest consumer
need, such as beauty parlors and car repair shops-that have not been merged and
consolidated by chaining or franchising.
Strategy in Embryonic and Growth Industries Embryonic industries
are typically created by the innovations of pioneering companies. But high
profits that innovating companies often reap in an embryonic industry also
attract potential imitators, spurring them to enter the market. Typically, such
entry is most rapid in the growth stage of an industry and may cause the
innovator to lose its commanding competitive position. The following Figure
shows how the profit rate enjoyed by the innovator in an embryonic industry can
decline as imitators crowd into the market during its growth stage. Thus
Apple's onetime monopoly position was competed away as hordes of other personal
computer makers entered into the market in the early and mid 1980s, trying to
share in Apple's success. Once its patents expired, Xerox, too, faced many
imitators, and some of them, such as Canon and Ricoh were ultimately very
successful in the photocopier market. In the fast-food market, the early
success of McDonald's drew imitators including Burger King, Wendy's, and
Foodmaker, with its Jack-in-the-Box restaurants.
Figure:
Figure:
How an Innovator’s Profits Can Be Competed Away
Given the inevitability of imitation, the key issue for an
innovating company in an embryonic industry is how to exploit innovation and
build an enduring long-run competitive advantage based on low cost or
differentiation. Three strategies are available to the company: (1) to develop
and market the innovation itself; (2) to develop and market the innovation
jointly with other companies through a strategic alliance or joint venture; and
(3) to license the innovation to others and let them develop the market.
The optimal choice of strategy depends on three factors. First,
does the innovating company have the complementary assets to exploit its
innovation and obtain a competitive advantage? Second, how difficult is it for
imitators to copy the company's innovation—in other words, what is the height
of barriers to imitation? And third, are there capable competitors that could
rapidly imitate the innovation? Before we discuss the optimal choice of
innovation strategy, we need to examine these factors.
Complementary Assets: Complementary assets are the assets required to successfully
exploit a new innovation and gain a competitive advantage. Among the most
important complementary assets are competitive manufacturing facilities capable
of handling rapid growth while maintaining high product quality. Such
facilities enable the innovator to move quickly down the experience curve
without encountering production bottlenecks and/or product quality problems. An
inability to satisfy demand because of these problems can create an opportunity
for imitators to enter the marketplace.
Complementary assets also include marketing know-how, an adequate
sales force, access to distribution systems, and an after-sales service and
support network. All of these assets can help an innovator build brand loyalty.
They also help the innovator achieve market penetration more rapidly.
Barriers to Imitation: We first consider barriers to imitation in Chapter 4, in
discussing the durability, of competitive advantage. As you may recall,
barriers to imitation are factors that prevent rivals from imitating a
company's distinctive competencies. They can also be viewed as factors that
prevent rivals, particularly late movers, from imitating a company's
innovation. Although ultimately any innovation can be copied, the higher the
barriers to imitation, the longer it takes for rival, to imitate the
innovation. Barriers to imitation give an innovator time to establish a
competitive advantage and build more enduring entry barriers in the newly
created market.
Capable Competitors: Competitors’ capability to imitate a pioneer’s innovation depends
primarily on two factors: (1) R&D skills and (2) access to complementary
assets. Other things being equal, the greater the number of capable competitors
with to the R&D skills and, complementary assets needed to imitate an
innovation, the more rapid is imitation likely to be. R&D skills are the
ability of rivals to reverse-engineer an innovation in order to find out how it
works and quickly develop a comparable product.
Three Innovation
Strategies: The way in which these three factors— complementary assets,
barriers to imitation, and the capacity of competitors— influence the choice
of innovation strategy is summarized in the following Table. The strategy of
developing and marketing the innovation alone makes most sense when the
barriers to imitating a new innovation are high, when the innovator has the
complementary assets necessary to develop the innovation, and when the number
of capable competitors is limited. High barriers to imitation buy the
innovator time to establish a competitive advantage and build enduring
barriers to entry through brand loyalty and/or experience- based cost
advantages. Complementary assets allow rapid development and promotion of the
innovation. The fewer the number of capable competitors, the less likely it
is that any one of them will succeed in circumventing barriers to imitation
and quickly imitating the innovation.
Strategies
for Profiting from Innovation
|
|||
Strategy
|
Does
Innovator Have All Required Complementary Assets?
|
Likely
Height of Barriers to Imitation
|
Number
of Capable Competitors
|
Go
It Alone
|
Yes
|
High
|
Few
|
Enter
into
|
No
|
High
|
Limited
|
License
Innovation
|
No
|
Low
|
Many
|
The strategy of developing and marketing the innovation jointly
with other companies through a strategic alliance or joint venture makes most
sense when barriers to imitation are high, there are several capable
competitors, and the innovator lacks complementary assets. In such
circumstances, it makes sense to enter into an alliance with a company that
already has the complementary assets, in other words, with a capable
competitor. Theoretically, such an alliance should prove to be mutually
beneficial, and each partner can share in high profits that neither could earn
on its own.
The third strategy, licensing, makes most sense when barriers to
imitation are low, the innovating company lacks the complementary assets, and
there are many capable competitors. The combination of low barriers to
imitation and many capable competitors makes rapid imitation almost certain.
The innovator's lack of complementary assets further suggests that an imitator
will soon capture the innovator's competitive advantage. Given these factors,
since rapid diffusion of the innovator's technology through imitation is
inevitable, by licensing out its technology the innovator can at least share in
some of the benefits of this diffusion. Strategy in Mature
Industries
As a result of fierce competition in the shakeout stage, an
industry becomes consolidated, and so a mature industry is often dominated by a
small number of large companies. Although it may also contain medium-sized
companies and a host of small specialized ones, the large companies determine
the nature of industry competition because they can influence the five
competitive forces. Indeed, these are the companies that developed the most
successful generic competitive strategies to manage the industry environment.
By the end of the shakeout stage, strategic groups of companies
pursuing similar generic competitive strategies have emerged in the industry.
For example, all the companies pursuing a low-cost strategy can be viewed as
composing one strategic group. All those pursuing differentiation constitute
another, and the focusers form a third. Companies have learned to analyze each
other's strategies, and they know that their competitive actions will stimulate
a competitive response from rivals in their strategic group and from companies
in other groups that may be threatened by these actions.
In mature industries, companies choose competitive moves to
maximize their competitive advantage within the structure of industry
competition. Indeed, to understand business-level strategy in mature
industries, one must understand how large companies try to collectively
stabilize industry competition to prevent entry, industry overcapacity, or cutthroat
price competition, which would hurt all companies.
The generic strategy pursued by one company directly affects other
companies because companies are competing against one another in the same
industry. How, then, can companies manage industry competition so as to
simultaneously protect their individual competitive advantage and maintain
industry rules that preserve industry profitability. Strategies
to Deter Entry in Mature Industries
Industry companies can utilize three main methods to deter entry by
potential rivals and hence maintain and increase industry profitability. These
methods are product proliferation, price cutting, and maintaining excess
capacity.
Product Proliferation: Companies seldom produce just one product. Most commonly, they
produce a range of products aimed at different market segments so that they
have broad product lines. Sometimes, to reduce the threat of entry, companies
tailor their range of products to fill a wide range of niches, thus creating a
barrier to entry by potential competitors. This strategy of pursuing a broad
product line to deter entry is known as product proliferation.
Price Cutting: In some situations, pricing strategies involving price cutting can
be used to deter entry by other companies, thus protecting the profit margins
of companies already in an industry. For example, one price-cutting strategy is
to initially charge a high price for a product and seize short-term profits,
but then to aggressively cut prices in order to simultaneously build market share
and deter potential entrants. The incumbent companies signal to potential
entrants that if they do enter the industry, the incumbents will use their
competitive advantage to drive down prices to a level where new companies will
be unable to cover their costs. This pricing strategy also allows a company to
ride down the experience curve and obtain economies of scale. Since costs would
be falling along with prices, profit margins could still be maintained.
Maintaining Excess Capacity: A further competitive technique that
allows companies to deter entry is to maintain a certain amount of excess
productive capacity. As you will see in the next section, excess capacity is a
major factor affecting the level of competition in an industry because it may
lead to price cutting and reduced industry profitability. However, existing
companies may prefer to possess some limited amount of excess capacity because
it serves to warn potential entrants that if they enter the industry, existing
firms can retaliate by increasing output and forcing down prices until entry
would become unprofitable. But the threat to increase output has to be
credible; collectively, industry incumbents must be able to quickly raise the
level of production if entry appears likely. Strategies to Manage
Rivalry in Mature Industries
Beyond seeking to deter entry, companies also wish to utilize
strategies to manage their competitive interdependence and decrease rivalry
because unrestricted competition over prices or output will reduce the level of
company and industry profitability. Several strategies are available to
companies to manage industry relations. The most important are price signaling,
price leadership, nonprice competition, and capacity control.
Price Signaling: Price signaling is the first means by which companies attempt to
structure industry competition in order to control rivalry among competitors.
Price signaling is the process by which companies convey their intentions to
other companies about pricing strategy and how they will compete in the future
or how they will react to the competitive moves of their rivals. There are
several ways in which price signaling can help companies defend their generic
competitive strategies.
First, companies may use price signaling to announce that they will
respond vigorously to hostile competitive moves that threaten them. For
example, companies may signal that if one company starts to cut prices
aggressively they will respond in kind to maintain the status quo and prevent
any company from gaining a competitive advantage.
A second, and very important, purpose of price signaling is to
indirectly allow companies to coordinate their actions and avoid costly
competitive moves that lead to a breakdown in industry pricing policy. One
company may signal that it intends to lower prices because it wishes to attract
customers who are switching to the products of another industry, not because it
wishes to stimulate a price war. On the other hand, signaling can be used to
improve industry profitability.
Price Leadership: Price leadership—the taking on by one company of the
responsibility for setting industry prices-is another way of using price
signaling to enhance the profitability of product/market policy among companies
in a mature industry. By setting prices, the industry leader implicitly creates
the price standards that other companies will follow. The price leader is
generally the strongest company in the industry, the one with the best ability
to threaten other companies that might cut prices or increase their output to
seize more market share.
Nonprice Competition: A third very important aspect of product/market strategy in mature
industries is the use of nonprice competition to manage industry rivalry.
Applying various techniques to try to prevent costly price cutting and price
wars does not preclude competition by product differentiation. In many
industries, product differentiation is used as the principal competitive weapon
to prevent competitors from obtaining access to a company's customers and
attacking its market share. In other words, companies rely, on product
differentiation to deter potential entrants and manage industry rivalry. It
allows them to compete for market share by offering products with different or
superior features or by applying, different marketing techniques.
Figure:
Four Non-Price Competitive Strategies
Market Penetration: When a company concentrates on expanding market share in its
existing product markets, it is engaging in a strategy of market penetration.
Market penetration involves advertising to promote and build market for product
differentiation. In a mature Industry, the thrust of advertising is to
influence consumer brand choice and create a brand name reputation for the
company and its products. In this way, a company can increase its market share
by attracting the customers of its rivals. Because brand name products often
command premium prices, building market share in this situation is very
profitable.
Product Development: Product development is the creation of new or improved products to
replace existing ones. The wet shaving industry exemplifies an industry that
depends on product replacement to create successive waves of consumer demand,
which then create new sources of revenue for industry companies. In 1989, for instance,
Gillette came out with its new Sensor shaving system, giving a massive boost to
its market share. In turn, Wilkinson Sword responded with its version of the
product.
Product development is important for maintaining product
differentiation and building market share. For instance, the laundry detergent
Tide has gone through more than fifty different changes in formulation during
the past forty years to improve its performance.
Market Development: Market development involves finding new market segments for a
company's products. A company pursuing this strategy wants to capitalize on the
brand name it has developed in one market segment by locating new market
segments in which to compete. In this way, it can exploit the product
differentiation advantages of its brand name.
Product Proliferation: Product proliferation can be used to manage industry rivalry, as
well as to deter entry. The strategy of product proliferation generally means
the large companies in an industry all have a product in each market segment or
niche and compete head-to-head for customers. If a new niche develops, like
convertibles or oat bran cereals, then the leader gets a first-mover advantage,
but soon all the other companies catch up, and once again competition is
stabilized and industry rivalry is reduced. Product proliferation thus allows
the development of stable industry competition based on product
differentiation, not price-that is, nonprice competition based on the
development of new products. The battle is over a product's perceived quality
and uniqueness, not over its price.
Capacity Control: Although nonprice competition helps mature industries avoid the
cutthroat competing that reduces both company and industry levels of
profitability, in some industries price competition does periodically break
out. This occurs most commonly when there is industry overcapacity, that is,
when companies collectively produce too much output so that reducing price is
the only way to dispose of it. If one company starts to cut prices, then the
others quickly follow because they fear that the price cutter will be able to
sell all its inventory and they will be left holding unwanted goods. Capacity
control strategies can influence the level of industry output.
Excess capacity may be caused by a shortfall in demand, as when a
recession lowers the demand for automobiles and causes companies to give
customers price incentives. In that situation, companies can do nothing except
wait for better times. However, by and large excess capacity results from
industry companies’ simultaneous response to favorable conditions: they all
invest in new plants to be able to take advantage of the predicted upsurge in
demand. Paradoxically, each individual company's effort to outperform the
others means that collectively the companies create industry overcapacity,
which hurts them all. The following Figure illustrates this situation.
Figure:
Changes in Industry Capacity and Demand
Choosing a Capacity Control Strategy: In general, companies
have two strategic choices: (1) each company individually must try to preempt
its rivals and seize the initiative, or (2) the companies collectively must
find indirect means of coordinating with each other so that they are all aware
of the mutual effects of their actions.
To preempt rivals, a company must forecast a large increase in
demand in the product market and then move rapidly to establish large-scale
operations that will be able to satisfy the predicted demand. By achieving a
first-mover advantage, the company may deter other firms from entering the
market since the preemptor will usually be able to move down the experience
curve, reduces its costs and therefore its prices as well, and threaten a price
war if necessary.
As for coordination as a capacity control strategy, collusion on
the timing of new investments is illegal under antitrust law, but tacit
coordination is practiced in many industries as companies attempt to understand
and forecast the competitive moves of their rivals. Generally, companies use
market signaling to secure coordination. They make announcements about their
future investment decisions in trade journals and newspapers. In addition, they
share information about their production levels and their forecasts of industry
demand so as to bring industry supply and demand into equilibrium. Thus a
coordination strategy reduces the risks associated with investment in the
industry.
Strategy
in the Global Environment Profiting From Global
Expansion
Expanding globally allows companies, large or small, to increase
their profitability in ways not available to purely domestic enterprises.
Companies that operate internationally can (1) earn a greater return from their
distinctive competencies; (2) realize what we refer to as location economies by
dispersing individual value creation activities to those location where they
can be performed most efficiently; and (3) ride down the experience curve ahead
of competitors, thereby lowering the costs of value creation.
Transferring Distinctive Competencies: Distinctive competencies
are defined there as unique strengths that allow a company to achieve superior
efficiency, quality, innovation, or customer responsiveness. Such strengths
typically find their expression in product offerings that other companies find
difficult to match or imitate. Thus distinctive competencies form the bedrock
of a company’s competitive advantage. They enable a company to lower costs or
value creation and/or to perform value-creation activities in ways that lead to
differentiation and premium pricing.
Companies with valuable distinctive competencies can often realize
enormous returns by applying those competencies, and the products they produce
to foreign market where indigenous competitors lack similar competencies and
products.
Realizing Location Economies: Location economies are the economies
that arise from performing a value creation activity in the optimal location
for that activity, wherever in the world that might be (transportation costs
and trade barriers permitting). Locating a value-creation activity in the
optimal location for that activity can have one of two effects: lower the costs
of value creation, helping the company achieve a low-cost position, or enable a
company to differentiate its product offering and charge a premium price. Thus
efforts to realize location economies are consistent with the generic
business-level strategies of low cost and differentiation.
Moving Down the Experience Curve: The experience curve
refers to the systematic decrease in production costs that have been observed
to occur over the life of a product. It follows that the key to riding down the
experience curve as rapidly as possible is to increase the accumulated volume
produced by a plant as quickly as possible. Since global markets are larger
than domestic markets, companies that serve a global market from a single
location are likely to build accumulated volume faster than companies that
focus primarily in serving their home market or on serving multiple markets
from multiple production locations. Thus serving a global market from a single
location is consistent with moving down the experience curve and establishing a
low-cost position. In addition, to get down the experience curve quickly,
companies need to price and market very aggressively so that demand expands
rapidly. They also need to build production capacity capable of serving a
global market. Another point to bear in mind is that the cost advantages of
serving the world market from a single location will be the more significant if
that location is also the optimal one for performing that value-creation
activity; that is, if the company is simultaneously realizing cost economies
from experience -curve effects and from location economies.
Pressures
for Cost Reductions and Local Responsiveness
Companies that compete in the global market place typically face
two types of competitive pressures: pressures for cost reductions and pressures
to be locally responsive. These competitive pressures place conflicting demands
on a company. Responding to pressures for cost reductions requires that a
company try to minimize its unit costs. To attain this goal a company may have
to base its productive activities at the most favorable low-cost location,
wherever in the world that might be. It may also have to offer a standardized
product to the global marketplace in order to ride down the experience curve as
quickly as possible. On the other hand, responding to pressures to be locally
responsive requires that a company differentiate its product offering and marketing
strategy from country to country in an effort to accommodate the diverse
demands arising from national differences in consumer tastes and preferences,
business practices, distribution channels, competitive conditions, and
government policies. Because differentiation across countries can involve
significant duplication and a lack of product standardization, it may raise
costs.
Pressures for Cost Reductions: Increasingly, international companies
must cope with pressures for cost reductions. To respond to these pressures, a
company needs to lower the costs of value creation by mass-producing a
standardized product at the optimal location in the world, in order to realize
location and experience curve-economies. Pressures for cost reductions can be
particularly intense in industries producing commodity-type products, where
meaningful differentiation on nonprice factors is difficult and price is the
main competitive weapon. Products that serve universal needs tend to fall into
this category. Universal needs exist when the tastes and preferences of
consumers in different nations are similar, if not identical. This obviously,
applies to conventional commodity products such as bulk chemicals. petroleum,
steel, sugar, and the like. It also tends to be true for many industrial and
consumer products-for instance, hand-held calculators, semiconductor chips, and
personal computers. Pressures for cost reductions are also intense in
industries where major competitors are based in low-cost locations, where there
is persistent excess capacity, and where consumers are powerful and face low
switching costs. Many commentators have also argued that the liberalization of
the world trade and investment environment in recent decades has generally
increased cost pressures by facilitating greater international competition.
Pressures for Local Responsiveness: Pressures for local
responsiveness arise from differences in consumer tastes and preferences;
differences in infrastructure and traditional practices; differences in
distribution channels; and host government demands.
Differences in Consumer Tastes and Preferences: Strong pressures for
local responsiveness emerge, when consumer tastes and preferences differ
significantly between countries, as they may for historic or cultural reasons.
In such cases, product and/or marketing messages have to be, customized to
appeal to the tastes and preferences of local consumers. This typically creates
pressures for the delegation of production and marketing functions to national
subsidiaries.
Differences in infrastructure and Traditional Practices: Pressures for local
responsiveness arise from differences in infrastructure and/or traditional
practices among countries, creating a need to customize products accordingly.
Fulfilling this need may require the delegation of manufacturing and production
functions to foreign subsidiaries.
Differences in Distribution Channels: A company's marketing
strategies may have to be responsive to differences in distribution channels
among countries. This may necessitate the delegation of marketing functions to
national subsidiaries.
Host Government Demands: Economic and political demands imposed by host country governments
may necessitate a degree of local responsiveness. For example the politics of
health care around the world requires that pharmaceutical companies manufacture
in multiple locations. Pharmaceutical companies are subject to local clinical
testing, registration procedures, and pricing restrictions, all of which make
it necessary that the manufacturing and marketing of a drug should meet local
requirements. Moreover, since governments and government agencies control a
significant proportion of the health care budget in most countries, they are in
a powerful position to demand a high level of local responsiveness. More
generally, threats of protectionism, economic nationalism, and local content
rules which dictate that a certain percentage of a product should be
manufactured locally all dictate that international businesses manufactured
locally. Part of the motivation for Japanese auto companies setting up U.S.
Implications: Pressures for local responsiveness imply that it may not be
possible for a company to realize the full benefits from experience-curve and
location economies. For example, it may not be possible to serve the global
marketplace from a single low-cost location, producing a globally standardized
product and marketing it worldwide to achieve experience-curve cost economies.
In practice, the need to customize the product offering to local conditions may
work against the implementation of such a strategy. Automobile companies, for
instance, have found that Japanese, American, and European consumers demand
different kinds of cars, which means customizing products for local markets. In
response, companies like Honda, Ford, and Toyota
Strategic
Choice There are
four basic strategies that companies use to enter and compete in the
international environment: an international strategy, a multi domestic
strategy, a global strategy, and a transnational strategy. Each of these
strategies has its advantages and disadvantages. The appropriateness of each
strategy varies with the extent of pressures for cost reductions and local
responsiveness. The following Figure illustrates when each of these strategies
is most appropriate. In this section we describe each strategy, identify when it
is appropriate, and discuss its pros and cons.
Figure:
Four Basic Strategies
International Strategy: Companies that pursue an international strategy try to create
value by transferring valuable skills and products to foreign markets where
indigenous competitor lack those skills and products. Most international
companies have created value by transferring differentiated product offerings
developed at home to new markets overseas. Accordingly, they tend to centralize
product development functions (for instance, R&D) at home. However, they
also tend to establish manufacturing and marketing functions in each major
country in which they do business. But although they may undertake some local
customization of product offering and marketing strategy, this tends to be
rather limited in scope. Ultimately, in most international companies the head
office retains tight control over marketing and product strategy.
An international strategy makes sense if a company has a valuable
distinctive competency that indigenous competitors in foreign markets lack and
if the company faces relatively weak pressures for local responsiveness and
cost reductions. In such circumstances, an international strategy can be very
profitable. However, when pressures for local responsiveness are high,
companies pursuing this strategy lose our to companies that place a greater
emphasis on customizing, the product offering and market strategy to local
conditions. Moreover, because of the duplication of manufacturing facilities,
companies that pursue an international strategy tend to inappropriate in
industries where cost pressures are high
Multi domestic Strategy: Companies
pursuing a multi domestic strategy orient themselves toward achieving maximum
local responsiveness. Like companies pursuing an international strategy, they
tend to transfer skills and products developed at home to foreign markets.
However, unlike international companies, multi domestic ones extensively
customize both their product offering and their marketing strategy to different
national conditions. Consistent with this approach, they also tend to establish
a complete set of value-creation activities— including production, marketing,
and R&D— in each major national market in which they do business. As a
result, they generally cannot realize value from experience-curve effects and
location economics and therefore often have a high-cost structure.
A multi domestic strategy makes most sense when there are high
pressures for local responsiveness and low pressures for cost reductions. The
high-cost structure associated with the duplication of production facilities
makes this strategy inappropriate in industries where cost pressures are
intense. Another weakness of this strategy is due to the fact that many multi domestic
companies have developed into decentralized federations in which each national
subsidiary functions in a largely autonomous manner. Consequently, after a time
they begin to lose the ability to transfer the skills and products derived from
distinctive competencies to their various national subsidiaries around the
world.
Global Strategy: Companies that pursue a global strategy focus on increasing
profitability by reaping the cost reductions that come from experience-curve
effects and location economies. That is, they are pursuing a low-cost strategy.
The production, marketing, and R&D activities of companies pursuing a
global strategy are concentrated in a few favorable locations. Global companies
tend not to customize their product offering and marketing strategy to local
conditions. This is because customization raises costs since it involves
shorter production runs and the duplication of functions. Instead, global
companies prefer to market a standardized product worldwide so that they can
reap the maximum benefits from the economies of scale that underlie the
experience curve. They also tend to use their cost advantage to support
aggressive pricing in world markets.
This strategy makes most sense in those cases where there are
strong pressures for cost reductions and where demands for local responsiveness
are minimal. Increasingly, these conditions prevail in many industrial goods
industries. In the semiconductor industry, for example, global standards have
emerged, creating enormous demands for standardized global products.
Accordingly, companies such as Intel, Texas Instruments, and Motorola all
pursue a global strategy. However, these conditions are not found in many
consumer goods markets, where demands for local responsiveness remain high (as
in the markets for audio players, automobiles, and processed food products).
The strategy is inappropriate when demands for local responsiveness are high.
Transnational Strategy: In today’s environment, competitive conditions are so intense that
in order to survive in the global marketplace companies must exploit
experience- based cost economies and location economies, transfer distinctive
competencies within the company, and at the same time pay attention to
pressures for local responsiveness. Moreover, in the modern multinational
enterprise, distinctive competencies do not reside just in the home country but
they can develop in any of the company’s worldwide operations. The flow of
skills and product offerings should not be all one way, from home company to
foreign subsidiary, as in the case of companies pursuing an international
strategy. Rather, the flow should also be from foreign subsidiary to home
country, and from foreign subsidiary to foreign subsidiary— a process referred
to as global learning. The strategy pursued by companies that are trying to
achieve all of these objectives simultaneously is called a transnational
strategy.
A transnational strategy makes sense when a company faces high
pressures for cost reductions and high pressures for local responsiveness. In essence,
companies that pursue a transnational strategy are trying to simultaneous1y
achieve low-cost and differentiation advantages. In practice the strategy is
not an easy one to pursue. As mentioned earlier, pressures for local
responsiveness and cost reductions place conflicting demands on a company.
Being locally responsive raises costs, which obviously makes cost reductions
difficult to achieve. To pursue a transnational strategy effectively, a company
can do the followings.
To deal with cost pressures, a company can redesign its products
to use many identical components and invested in a few large-scale component
manufacturing facilities, sited at favorable locations, to fill global demand
and realize scale economies. At the same time the company augments the
centralized manufacturing of components with assembly plants in each of its
major global markets. At these plans it can add local product features,
tailoring the finished product to local needs. Thus the company would be able
to realize many of the benefits of global manufacturing while reacting to
pressures for local responsiveness by differentiating its product among
national markets.
Summary: The advantages and
disadvantages of each of the four strategies discussed above are summarized
in the following Table. Although a transnational strategy appears to offer
the most advantages, it should not be forgotten that implementing it raises
difficult organizational issues. More generally, the appropriateness of each
strategy depends on the relative strength of pressures for cost reductions
and for local responsiveness.
The
Advantages and Disadvantages of the Four Traditional Strategies
|
||
Strategy
|
Advantages
|
Disadvantages
|
Global
|
Ability
to exploit experience-curve effect
Ability to exploit location economies
|
Lack of local responsiveness
|
International
|
Transfer of distinctive competencies
to foreign markets
|
Lack of local responsiveness
Inability to realize location
economies
Failure to exploit experience-curve
effect
|
Multi
domestic
|
Ability to customize product offerings
and marketing in accordance with local responsiveness
|
Inability to realize location
economics
Failure to exploit experience-curve
effect
Failure to transfer distinctive
competencies to foreign markets
|
Transnational
|
Ability to exploit experience-curve
effects
Ability to exploit location economics
Ability to customize product offerings and marketing in accordance with local
responsiveness
Reaping benefits of global learning
|
|
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