Creating Competitive Advantage: Ghemawat, Chapter Three Notes

Creating Competitive
Advantage
Ghemawat, Chapter Three Notes
Darral G. Clarke for BM 499
Average Economic Profits in

the Steel Industry, 1978 -1996
ROE-Ke Spread
40%
Great Northern Iron
30%
20%
Worthington Inds
Nucor
Steel Technologies
Oregon Mills
10%
Commercial Metals
0%
Carpenter
Birmingham
British Steel PLC

Cleveland-Cliffs
Quanex
Lukens
ACME Metals
Ampco
(10%)
USX-US Steel
Inland Steel
(20%)
(30%)
$0
$1
$2
$3
$4
Average Invested Equity ($B)

$5
$6
$7
$8
$9
$10
Armco
WHX Bethlehem
$11
$12
$13
$14
$15
Source: Compustat, Value Line, Marakon Associates Analysis
Average Economic Profits in

the Drug Industry, 1978 -1996
ROE-Ke Spread
60%
SmithKline
40%
Glaxo
American
Amgen
Home
Products
Merck
20%
Schering Plough
Watson
Rhone-Poulenc
Mylan Labs
Bristol
Warner Lambert
Myers
Eli Lilly
Pfizer
Perrigo
Pharmacia & Upjohn
Forest Labs
Alza
0%
ICN
Scherer
Ivax
Genetech
Biogen
Roberts
Genzyme
Dura
Chiron
Cephalon
Gensia
Cygnus
Immunex
(20%)
(40%)
(60%)
Average Invested Equity ($B)
(80%)
$0
$5
$10
$15
$20
$25
$30
Source: Compustat, Value Line, Marakon Associates Analysis
Calibrating Profit Drivers

Residual
Industry
Corporate
Source: Richard P. Rumelt, How Much Does Industry Matter?,
Strategic Management Journal, 1991; 12:167-185
Positioning
Added Value
Added value =
total industry value created with the firm in

the game
- total value created without the firm in the
game
OR EQUIVALENTLY
the value that would be lost to the industry
if the firm disappeared
Under unrestricted bargaining, a firm cannot capture more

than its added value
If you (in your relationships with customers and suppliers) create

no value, you can capture no value
More generally, if a firm (in its relationships) creates no new

value, it had better have some clever way of claiming value
Value Creation
Customer
Firm
Supplier
Value is created by a business

operating together with its customers
Willingness to pay
and its suppliers
A firm does not create value in
isolation
Willingness to pay = the most that a
customer will pay for a firms product
Total value created Supplier opportunity cost = willingness
to receive = the least that a supplier
will accept for the resources required
to make a product
The value created by a transaction is
the difference between the
Supplier opportunity cost customers willingness to pay and the
opportunity cost of the resources
Value Division
Customer
Willingness to pay
Value captured by customer

Price
Firm
Value captured by firm

Cost
Value captured by supplier
Supplier
Supplier opportunity cost
Activity Analysis of
Competitive Advantage
Added value => goal is to drive a wedge between
willingness to pay and (supplier opportunity) cost
Indeed, a wider wedge than competitors achieve
Problem: a firm must often incur higher costs to

deliver a better product or service
Partial solution: use activity analysis to spot
opportunities to widen the wedge
McKinseys Business System

Technology
Design
Development
Manufacturing
Procurement
Assembly
Distribution
Transport
Inventory
Marketing
Retailing
Advertising
Service
Parts
Labor
Source: Carter F. Bales, P.C. Chatterjee, Donald J. Gogel, and

Anapam P. Puri,
Competitive Cost Analysis, McKinsey & Co. Staff Paper (January
1980)
Value Chain for an Internet

Start-Up
Firm
Infrastructure
Support
Activities
Financing, legal support, accounting
Human Resources
Recruiting, training, incentive system, employee feedback
Technology
Development
Inventory
system
Procurement
CDs
Shipping
Computers
Telecom lines
Inbound
shipment
of top
titles
Warehousing
Server
operations
Site software
Pick & pack

procedures
Site look
& feel
Return
procedures
Customer
research
Inbound
Logistics
Billing
Collections
Operations
Shipping
services
Picking and
shipment of top
titles from
warehouse
Shipment of
other titles
from thirdparty
distributors
Outbound
Logistics
Medi
a
Pricing
Returned items
Promotions
Customer feedback
Advertising
Primary
activities
Product
information and
reviews
Affiliations
with other
websites
Marketing
& Sales
After-Sales
Service
Primary Activities
10
Porters Generic Strategies

STRATEGIC ADVANTAGE
STRATEGIC TARGET
Uniqueness Perceived
by the Customer
Industry wide
DIFFERENTIATION
Low Cost Position
OVERALL
COST LEADERSHIP
Stuck in
The middle
Particular
Segment only
FOCUS
Source: Michael Porter, Competitive Strategy, 1980
11
Small group exercise: Name the

generic strategies in our cases
Coca Cola
PepsiCo
Continental Can
Crown Cork and Seal
12
Interplay between Cost and

Differentiation
price
$
cost
Industry
average
competitor
1.
2.
3.
13
Porters Generic Strategies

Low cost leadership
Differentiation
Dc
Ci
Cc
Di
Cc
Cc
Ci
Di
Focus: Low cost or differentiation in a market segment.
14
Cost Leadership Strategy

Deliver a GOOD product or service at the lowest possible cost
Open a significant and sustainable cost gap over all
competitors
Create advantage through superior management of key cost
drivers
Translates into above-average profits with industry-average
prices
BUT
Cost leaders must maintain product parity or proximity in

satisfying buyer needs
Cost leadership often requires making trade-offs with
differentiation
15
Cost Drivers
Scale
Learning
Pattern of capacity
utilization
Linkages
Interrelationships
Integration
Timing
Policies
Location
Institutional
factors
Source: Michael E. Porter, Competitive Advantage

(New York: Free Press, 1985)
16
Common Pitfalls in Cost

Leadership
Misunderstanding of actual costs
False perception of cost drivers
Focus on manufacturing
Failure to exploit linkages
Inadequate proximity to differentiators
Ignoring competitor behavior
Poor implementation
Acting incrementally
No cost management program
17
The Differentiation Strategy

Select one or more needs that are valued by buyer
Achieve and sustain superior performance by meeting
these needs uniquely
Selectively add costs if necessary to do so
Successful differentiation leads to premium prices
Differentiators must pick cost-effective forms of
differentiation
Differentiation leads to above-average profitability
provided the firm maintains cost parity or
proximity to competitors
18
Common Pitfalls in
Differentiation
Creating differentiation that buyers do not value
Over-fulfilling buyer needs
Looking too narrowly at the sources of differentiation
Charging an excessive price premium
Failing to understand costs of differentiation
Ignoring signals of value
Failing to recognize buyer segments
Creating differentiation that competitors can emulate
quickly or cheaply
19
Focus Strategy
Exploits the same fundamental types of competitive
advantage
Selects narrow target segment(s) with unusual needs
Creates optimal strategy for the target
Narrowing of scope creates cost or

differentiation advantage
20
Can business do more than one?

Overall Cost
Leadership
+
Differentiation
OR
Sometimes consistent
But requires defense
against a competitor
achieving one or the
other
Focus
Can have
multiplyfocused
entities in one
company
21
Stuck in the middle

A company can be stuck in the middle if
A differentiator attempts to cut costs that are essential

to its differentiation
A low cost leader incurs costs, above those which are
essential to its low cost position, which do not
differentiate the product
A focus company attempts to broaden its strategic
target beyond the segments in which it has an advantage
In other words, by incurring costs, or by cutting

costs, or by pursuing markets that reduce the
wedge
22
An Expanded Version of
Generic Strategies
Extend BCG framework to include a
broader set of cost structures
Extend Porters five forces to recognize a
more diverse set of competitive
environments
Apply the economic theory of long run
average cost
23
Cost/unit
LRAC Review
E
x
p
e
ri
e
n
c
e
Scale
E
x
p
e
ri
e
n
c
e
New technology
Experience advantages decline with volume,

Scale advantages exhausted at optimal scale,
If no change in technology, no advantage to volume
LRAC
Volume
24
Strategy and long-run average

cost
Cost advantage from volume
Low
High
Ability to
differentiate
product
High
Fragmented
Profitable
&
Defensible
Stalemate
Volume
Low
25
Competitive Strategy and Long

Run Cost/Differentiation I
Volume Industry
Low cost leadership type markets

There is an advantage in scale or technology
Stalemate Industry
Cant differentiate
Economies of scale, experience common to
competitors
No process innovation
26
Competitive Strategy and Long

Run Cost/Differentiation II
Fragmented Industry
Differentiation is key competitive factor

Niche strategy
Volume in niches inadequate to achieve volume cost
advantages
Profitable and defensible industry
Differentiated product
Customer preference
Low cost producer of differentiated product
Transitory industry
Cost advantage based on labor

Cost advantage based on any other temporary advantage
27
Small group exercise: Provide an

example of a cost leadership
strategy in one of our cases
(identify the company and provide some detail)
Cola wars and

beverage industry
Coors and brewing
industry
Crown Cork and Seal
DeBeers and the
diamond industry
Egghead and the retail

industry
Barnes and Noble,
Amazon and the retail
book industry
28

example of a differentiation
strategy in one of our cases
Cola wars and
beverage industry
Coors and brewing
industry
Crown Cork and Seal
DeBeers and the
diamond industry

industry
Barnes and Noble,
book industry
29

example of a focus strategy (either
cost or differentiation) strategy in one
of our cases
Cola wars and
beverage industry
Coors and brewing
industry
Crown Cork and Seal
DeBeers and the
diamond industry

industry
Barnes and Noble,
book industry
30

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Creating Competitive

Darral G. Clarke for BM 499

Average Economic Profits in

British Steel PLC

Average Invested Equity ($B)

Source: Compustat, Value Line, Marakon Associates Analysis

Darral G. Clarke for BM 499

Average Economic Profits in

Source: Compustat, Value Line, Marakon Associates Analysis

Darral G. Clarke for BM 499

Calibrating Profit Drivers

Darral G. Clarke for BM 499

total industry value created with the firm in

Under unrestricted bargaining, a firm cannot capture more

If you (in your relationships with customers and suppliers) create

More generally, if a firm (in its relationships) creates no new

Value is created by a business

Darral G. Clarke for BM 499

Value captured by customer

Value captured by firm

Value captured by supplier

Supplier opportunity cost

Darral G. Clarke for BM 499

Indeed, a wider wedge than competitors achieve

Problem: a firm must often incur higher costs to

Darral G. Clarke for BM 499

McKinseys Business System

Source: Carter F. Bales, P.C. Chatterjee, Donald J. Gogel, and

Darral G. Clarke for BM 499

Value Chain for an Internet

Financing, legal support, accounting

Recruiting, training, incentive system, employee feedback

Pick & pack

Darral G. Clarke for BM 499

Porters Generic Strategies

Low Cost Position

Darral G. Clarke for BM 499

Small group exercise: Name the

Darral G. Clarke for BM 499

Interplay between Cost and

Darral G. Clarke for BM 499

Porters Generic Strategies

Focus: Low cost or differentiation in a market segment.

Darral G. Clarke for BM 499

Cost Leadership Strategy

Cost leaders must maintain product parity or proximity in

Darral G. Clarke for BM 499

Source: Michael E. Porter, Competitive Advantage

Darral G. Clarke for BM 499

Common Pitfalls in Cost

Darral G. Clarke for BM 499

The Differentiation Strategy

Darral G. Clarke for BM 499

Narrowing of scope creates cost or

Can business do more than one?

Stuck in the middle

A differentiator attempts to cut costs that are essential

In other words, by incurring costs, or by cutting

Darral G. Clarke for BM 499

Experience advantages decline with volume,

Strategy and long-run average

Darral G. Clarke for BM 499