Creating Competitive

Advantage
Ghemawat, Chapter Three Notes

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Average Economic Profits in
the Steel Industry, 1978 -1996
ROE-Ke Spread
40% Great Northern Iron

30%

20%
Worthington Inds
Nucor
Steel Technologies
10%
Oregon Mills
Commercial Metals
0%
Carpenter British Steel PLC
Birmingham Cleveland-Cliffs
Quanex
(10%) Lukens USX-US Steel
ACME Metals
Ampco
Inland Steel
(20%)

Armco
Average Invested Equity ($B) WHX Bethlehem
(30%)
$0 $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 $11 $12 $13 $14 $15

Source: Compustat, Value Line, Marakon Associates Analysis

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Average Economic Profits in
the Drug Industry, 1978 -1996
ROE-Ke Spread
60%
SmithKline

American Schering Plough

40%
Home Amgen Watson Rhone-Poulenc
Glaxo Products Mylan Labs
Merck Bristol
Myers Warner Lambert Perrigo
20% Pharmacia & Upjohn
Eli Lilly Pfizer Forest Labs
Alza
0%
ICN
Scherer
Ivax
(20%) Genetech
Biogen
Roberts
Genzyme
(40%) Dura
Chiron
Cephalon
(60%) Gensia
Cygnus
Immunex
Average Invested Equity ($B)
(80%)
$0 $5 $10 $15 $20 $25 $30

Source: Compustat, Value Line, Marakon Associates Analysis

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 Calibrating Profit Drivers
Residual

Industry

Corporate

Source: Richard P. Rumelt, “How Much Does Industry Matter?,”

Strategic Management Journal, 1991; 12:167-185
Positioning

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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

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 Value Creation
• Value is created by a business
operating together with its customers
Customer 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 firm’s product
Firm 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 Supplier opportunity cost customer’s willingness to pay and the
opportunity cost of the resources

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 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

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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

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McKinsey’s Business System

Technology Manufacturing Distribution Marketing Service

Design Procurement Transport Retailing Parts

Development Assembly Inventory Advertising Labor

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

Anapam P. Puri,
“Competitive Cost Analysis,” McKinsey & Co. Staff Paper (January
1980)

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 Value Chain for an Internet
Start-Up
Firm
Infrastructure • Financing, legal support, accounting

Human Resources • Recruiting, training, incentive system, employee feedback

Support Technology • Inventory • Site software • Pick & pack • Site look • Return
Activities Development system procedures & feel procedures
• Customer
research

Procurement • CDs • Computers • Shipping •Medi

• Shipping • Telecom lines services a

• Inbound • Server • Picking and •Pricing • Returned items

shipment operations shipment of top
of top titles from •Promotions • Customer feedback
titles • Billing warehouse
• Warehousing •Advertising
• Collections • Shipment of
other titles •Product •Primary
from third- information and •activities
party reviews
distributors
•Affiliations
with other
websites
Inbound Operations Outbound Marketing After-Sales
Logistics Logistics & Sales Service

Primary Activities

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Porter’s Generic Strategies
STRATEGIC ADVANTAGE
Uniqueness Perceived
by the Customer Low Cost Position
STRATEGIC TARGET

OVERALL
Industry wide DIFFERENTIATION
COST LEADERSHIP

Stuck in
The middle
Particular
Segment only FOCUS

Source: Michael Porter, Competitive Strategy, 1980

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Small group exercise: Name the
generic strategies in our cases

Coca Cola
PepsiCo
Continental Can
Crown Cork and Seal

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Interplay between Cost and
Differentiation

price

$
cost

Industry 1. 2. 3.
average
competitor

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Porter’s Generic Strategies

Low cost leadership Differentiation

Dc
Cc
Ci Ci
Cc
Di Di
Cc

Focus: Low cost or differentiation in a market segment.

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 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

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Cost Drivers

Scale Integration
Learning Timing
Pattern of capacity Policies
utilization Location
Linkages Institutional
factors
Interrelationships

Source: Michael E. Porter, Competitive Advantage

(New York: Free Press, 1985)

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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

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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
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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

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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

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Can business do more than one?
Overall Cost
Leadership
OR
+
Differentiation
Focus
Sometimes consistent Can have
But requires defense multiply-
against a competitor focused
achieving one or the entities in one
other company

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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”

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An Expanded Version of
Generic Strategies
Extend BCG framework to include a
broader set of cost structures
Extend Porter’s five forces to recognize a
more diverse set of competitive
environments
Apply the economic theory of long run
average cost

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Cost/unit LRAC Review
E
x
p
e
E
ri
x
e
p
n
e
c
ri
e
e
Scale n
c
e

New technology LRAC

Experience advantages decline with volume, Volume

Scale advantages exhausted at optimal scale,
If no change in technology, no advantage to volume

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Strategy and long-run average
cost
Cost advantage from volume

Low High
High
Profitable
Fragmented &
Defensible
Ability to
differentiate
product
Stalemate Volume

Low

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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
 Can’t differentiate
 Economies of scale, experience common to
competitors
 No process innovation

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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

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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

Egghead and the retail
beverage industry industry
Coors and brewing Barnes and Noble,
industry Amazon and the retail
Crown Cork and Seal book industry
DeBeers and the
diamond industry
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Small group exercise: Provide an
example of a differentiation
strategy in one of our cases
(identify the company and provide some detail)

Cola wars and Egghead and the retail

beverage industry industry
Coors and brewing Barnes and Noble,
industry Amazon and the retail
Crown Cork and Seal book industry
DeBeers and the
diamond industry

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Small group exercise: Provide an
example of a focus strategy (either
cost or differentiation) strategy in one
of our cases
(identify the company and provide some detail)

Cola wars and Egghead and the retail

beverage industry industry
Coors and brewing Barnes and Noble,
industry Amazon and the retail
Crown Cork and Seal book industry
DeBeers and the
diamond industry

Darral G. Clarke for BM 499 30