"Competition Demystified", Bruce Greenwald and Judd Kahn

 

Strategic decision results depend on actions and reactions of other economic entities while tactical decisions are made in isolation and hinge largely on effective implementation… Choice of markets is strategic b/c it determines the cast of external characters who will effect a company’s economic future… leaders seeking to develop and pursue winning strategies should begin by ignoring Porter’s four other forces (Substitutes, Suppliers, Potential Entrants, Buyers and Competitors within an industry) and focus on Barriers to entry (entrants)… If no barriers to entry then there will be no ‘economic profit’- returns equal cost of the invested capital… Operational effectiveness is tactical… Being able to do what rivals cannot is the definition of competitive advantage. Thus barriers to entry and incumbent competitive advantages are simply two ways of describing the same thing…Globalization suggests that competitive advantages and barriers to entry will disappear, but this macro view misses one essential feature of competitive advantages, that competitive advantages are almost always grounded in ‘local’ circumstances… Establishing local dominance and then expanding into related territories accounts for two of the other great corporate achievements of the period, although in these cases the geography in question is product market space, not physical territory (MSFT expanded at edges, INTC started with memory and microprocessors)… Competitive advantages that lead to market dominance, either by a single company or by a small number of essentially equivalent firms, are much more likely to be found when the arena is local, bounded either geographically or in product space, than when it is large and scattered. That is b/c the sources of c/a as we will see, tend to be local and specific, not general or diffuse… Service industries becoming increasingly important and manufacturing less significant suggest opportunities for sustained competitive advantage, properly understood, are likely to increase not diminish. The chances of becoming the next MSFT/WMT are infinitesimal, but the focused company understands its markets and its particular strengths can still flourish…

 

There are only 3 kinds of genuine competitive advantage: 1) Supply- strictly cost advantages that allow a company to produce and deliver its products or services more cheaply, more frequently due to proprietary technology that is protected by patents or by experience, 2) Demand- some companies have access to market demand that their competitors cannot match, not simply a matter of product differentiation or branding, since competitors may equally be able to differentiate or brand their products. These demand advantages arise b/c of customer captivity that is based on habit, on the costs of switching, or on the difficulties and expenses of searching for a substitute 3) Economies of Scale- If costs per unit decline as volume increases, b/c fixed costs make up a large share of total costs, then even with the same basic technology, an incumbent with large scale will enjoy lower costs… Govt. protection of in financial markets superior access to information may also be c/a but these tend to be few…The benefits of operating in markets with limited boundaries is apparent, while difficulties remain for sustaining dominance boundaries are vast. Most companies that manage to grow and still achieve a high level of profitability due it in one of three ways 1) replicate their local advantages in multiple markets, like KO 2) they continue to focus within their product space as that space itself becomes larger, like INTC or 3) Like WMT and MSFT gradually expand their activities outward from the edges of their dominant market positions… Starting point for any strategic analysis is MKT by MKT assessment of existence and source if competitive advantage; if none than begins and ends with operational efficiency… For yes c/a then need to identify its nature and how to maintain… Ant/Elephant either get out if ant or look elsewhere; if incumbent advantage shrinks and barriers to entry disappear, the new firm will be one of many entrants pursuing profits on a level playing field- Grouch Marx rule not to join any club that will have him… Elephant priority is to sustain what it has: requires recognizing and thorough understanding of source and limits of its c/a which allows firm to reinforce and protect existing advantages and make incremental investments which can extend them, distinguishes potential areas for growth, highlights polices that extract maximum profitability from firm’s situation, spots threats that are likely to develop and identifies competitive inroads that requires strong countermeasures… INTC and MSFT dominate niches but compete indirectly for a share of the overall value created in the industry… For those that enjoy c/a but with potent competitor’s strategy formulation is most intense, need to know what competitors doing and anticipate competitor reactions… Game theory: players, actions each can pursue, motives, rules- who goes when, knows wheat and when, and penalties for breaking rules… Identify c/a and analyze prisoner dilemma (price and quality) and entry/preemption behavior- play game; alternative possibilities multiply rapidly… No barriers to entry, some firms do much better-mgmt.… Differentiation w/out barriers to entry ex. Mercedes, Cadillac, etc. make it difficult to translate power of brands into exceptionally profitable businesses- sales declined while fixed costs of their strategy-product development, advertising, maintaining dealer and service networks- did not contract… Pops would disappear after entrants had fragmented the market to such an extent that high fixed costs per unit eliminated any extraordinary profit… In sum, product differentiation does not eliminate corrosive-impact of competition- if no forces interfere process of entry by competitors, profitability will be driven to levels at which efficient firms earn no more than a ‘normal’ return on their invested capital- barriers to entry, not differentiation by itself, that creates strategic pop’s… In commodity business, efficient ops are largely a matter of controlling production costs. With differentiated products, efficiency is a matter of both production cost control and in all functions that underlie successful marketing… Unless something interferes with the processes of competitive entry and expansion, efficient operations in all aspects of the business are key to successful performance… If barriers exist, then firms within barriers must be able to do things other potential entrants cannot… Periods of oversupply last longer than periods in which demand exceeds capacity… Barriers to entry and competitive advantage are essentially alternative ways of describing the same thing. Only necessary qualification to this statement is that barriers to entry are identical to incumbent competitive advantages; whereas entrant competitive advantages- situations where latest to arrive in MKT enjoys an edge- are of limited and transitory value… Competitive advantages may be due to 1) superior production technology and/or privileged access to resources 2) customer preferences 3) combinations of economies of scale with some level of customer preference. Production advantages weakest barrier to entry; economies of scale when combined with some customer captivity are the strongest… Also advantages from govt. intervention, licenses, tariffs and quotas, authorized monopolies, patents, direct subsidies, and various kinds of regulation, i.e. TV broadcast licenses… One way to have c/a is to have lower cost structure that cannot be duplicated by rivals… Cost advantages based on patents are only sustainable for limited periods. Compared to IBM’s long term dominance in computers from 50’s to 90s for example, KO’s century long history in the soda market, patent protection is relatively brief… In industries with complicated processes, learning and experience are a major source of cost reduction; % of good yields in most chemical and semi processes often increases dramatically over time. Much depends on the pace of technological change, if swift enough, it can undermine advantages that are specific to processes that quickly become outdated (in the long run everything is a toaster)… If a particular approach can be fully understood by a few employees, competitors can hire them away and learn the essentials of the process… If cost advantages rooted in prop. Technology are relatively rare and short-lived, those based on lower input costs are rarer still… Access to cheap capital or deep pockets is another largely illusory advantage… Competitive demand advantages require that customers be captive in some degree to incumbent firms… KO- isn’t wise to antagonize captive customers… Habit succeeds in holding customers captive when purchases are frequent and virtually automatic, yet habitual user of Crest is not committed to Tide or any other PG products… Software is the product most easily associated with high switching costs- to retrain users… Few want to abandon a functioning system, even for one that holds vast productivity increase if it holds threat of terminating business through systemic failure… High search costs are an issue when products or services are complicated, customized and crucial… Taken together, habits, switching costs, and search costs create c/a’s on the demand side that are more common and generally more robust than advantages stemming from the supply or cost side. But even these advantages fade over time. New customers are unattached and available to anyone. Existing captive customers ultimately leave the scene; they move, they mature, they die… Only very few venerable products like Heinz ketchup seem to derive any long-term benefit from some intergenerational transfer of habit… c/a of economies of scale depend not on the absolute size of the dominant firm but on the size difference b/w it and its rivals, that is, on market share. If average costs per unit decline as a firm produces more, then smaller comps will not be able to match the costs of the large firm even though they have equal access to technology and resources so long as they cannot reach the same scale of operations. Larger firm can be profitable when smaller firm with higher avg. costs is losing money. The costs structure that underlies these economies of scale usually combines a significant level of fixed cost and a constant level of incremental variable costs. All can reach that in theory; need to have some degree of incumbent customer captivity. Incumbent can lower prices to a level where it alone is profitable and can increase share of MKT. If diligently defends, can maintain MKT share, why incumbent clearly need to understand c/a… Local more likely, one store can have foot traffic to survive in Nebraska, not New York… Special purpose niche market has easier time in creating and profiting from economies of scale than the general purpose PC competing in a much larger MKT… INTC R&D edge in tech and economies of scale in advertising… Three features of economies of scale have major implications for strategic decisions that incumbents must make.  1) C/A’s based on economies of scale must be defended…If rival initiates attractive new product features, leader must adopt them quickly- MSFT- Internet Explorer. Economies of scale need to be defended with eternal vigilance… 2) Pure size is not the same thing as economies of scale. Relevant market area- geographic or otherwise- in which the fixed costs stay fixed. If sales added outside the territory, fixed costs rise and economies of scale diminish. Network economies of scale gain be being part of densely populated network. In medical services 60% mkt share of doctors make AET more appealing to CI with 20%. GE always focused on relative share in particular MKT not its overall size… 3) Growth of a MKT is generally the enemy of a C/A which is based on economies of scale. The strength of this advantage is basically directly related to the importance of fixed costs. Also growth in the mkt lowers the hurdle an entrant must clear in order to become viably competitive… Operational effectiveness can make one company much more profitable than its rivals even in an industry with no C/A’s… Firms that are operationally effective, however, do tend to focus on a single business and on their own internal performance…  In competitive situations where a company enjoys advantages related to proprietary technologies and customer captivity, its strategy should be to both exploit and reinforce them where they can… If the source is cost advantages stemming from prop. Tech the company wants to improve them continually and to produce a successive wave of patentable innovations- need to make sure investments in R&D productive. If source is customer captivity, company needs to encourage habit formation in new customers… C/A based on economies of scale call by themselves for two reason 1) tend to be longer lived than the other two types and therefore more valuable. KO most valuable brand b/c customer captivity and more importantly, local economies of scale due to advertising and distribution; can appeal to them (advertising) and serve them (distribution) at a much lower cost than competitors... 2) advantages based on EOS are vulnerable to gradual erosion and must be vigorously defended. Once a competitor increases size and decrease unit cost, gap shrinks and next step easier… In a MKT with significant fixed costs but currently served by many small, an individual firms has an opportunity to acquire a dominant share; if also a degree of customer captivity that dominant share will be defensible… Even where incumbent dominant position, lack of vigilance may present openings. WMT won out over KMT and most of its other discount store competitors by extending its economies of scale into what had been the enemy’s territory. MSFT did same in application software. Economies of scale, especially in local markets, are the keys to creating sustainable competitive advantages…. Identify niches, not all of which are equally attractive. Attractive niche must be characterized by customer captivity, small mkt size relative to the fixed costs, and the absence of vigilant, dominant competitors. Ideally, would be readily extendable at the edges… Anything due to increase fixed costs, adverting heavily, accelerate product cycles thereby upping R&D cost increases defense likelihood… Grow and die can do the opposite; instead of defending, many sig. past failures spent copiously in MKTS where they were newcomers- growth obsessed CEO’s… Many companies, if look carefully will find markets where they can earn above normal return on investment… Local opp’s too often disregarded in the pursuit of ill-advised growth associated with global strategic approaches… Assessing comp. advantages:  1) Identify competitive landscape in which firms operates. Which markets is it really in? Who are the competitors in each one? 2) Test for the existence of competitive advantages in each MKT. Do incumbent firms maintain stable MKT shares? Are they exceptionally profitable over a substantial period? 3) Identify the likely nature of any c/a that may exist: prop tech, captive customers, economies of scale or regulatory hurdles from which they benefit… First Step is develop industry map that shows structure of competition in relevant markets? Map will identify the market segments that make up the industry as a whole and the leading competitors. Second step is determine for each MKT SEGMENT whether it is protected by barriers to entry. Two telltale signs of the existence of barriers to entry: stability of MKT share among firms; if companies regularly capture MKT share from each other, it is unlikely any have a protected position. If each can defend its share over time, than c/a may be protecting their individual MKT positions. Key indicator is history of dominant firm in the industry. The more turbulent the ranking, and the longer list of comp’s, the less likely barriers to entry. Second telltale sign is return on capital. After tax-returns of 15-28% which equates to 23-38% pre-tax over a decade or more are clear evidence of the presence of c/a. Problem is must attempt to disaggregate multi-segment company to determine if true c/a… Enron reported only 6% return on capital in 2000- its most profitable year…. If MKT share stability and profitability indicate the existence of c/a, the third step is to identify the source. Do dominant firms benefit from prop. tech or other cost advantage, captive customer, thanks to consumer habit formation, switching costs or search costs, economies of scale combined with at least some degree of cust. captivity? If none exist, do incumbent firms profit from the govt. intervention, such as licenses, subsidies, regulations, or some other special dispensation? Identifying the likely source confirm the data on the market share stability and profitability. Even when MKT share stability and profitability is high, a close look at the business may fail to sot any clearly identifiable cost, customer captivity, or economies of scale advantages. The likely explanation is either that stability and profitability are temporary, or that they are the consequences of good management- operational effectiveness- that can be emulated by any sufficiently focused entrant… Industry map: too much detail risks overwhelming the map with too many segments; too little detail risks missing important distinctions… Only four companies in the microprocessor segment, the list of PC manufacturers is both long and incomplete, and the identity of the dominant firm is not obvious… MKT value to estimated replacement cost of INTCs net assets has continually exceeded 3-1; each dollar invested has created 3 or more dollars in shareholder value. $1b in R&D and sells 100m chips per generation so R&D cost per chip $10 vs. Apple/MOT/IBM alliance $100 per chip… MSFT ROIC still above 40% if back out cash… Rule of thumb: if can’t count top firms in industry on fingers of one hand, chances are good no barriers to entry. Second rule of thumb, if absolute MKT share change exceeds 5% no barriers to entry, if 2% or less barriers are formdidable… EBIT: adjust for extraordinary items to yield ‘adjusted operating earnings’. Divide by revenue for ‘adjusted operating margin.’ Merchandise purchase major part of COGS, also inbound logistics, getting goods from vendor to stores or warehouses, WMT spent 2.8% vs. industry 4.1%, shrinkage 1.3% vs. industry 2.2%, extra-margin from single store towns .9% higher than KMT, lower rental by .3% of sales and payroll expenses by 1.1% (south). Both economies of scale and customer cap. Regional. What mattered in achieving economies of scale were number of stores within relevant boundaries, higher densities of stores and customers in region than competitors. Economy of scale has to be combined with some customer captivity in order to keep competitors at bay. WMT became considerably less profitable, measure by return on invested capital or operating margins. Int’l return on sales and capital appear to have been 1/3… Business trend change: End of WWII kegs more than 1/3 of all beer sales, by 1985 13%. Coors, vertically integrated to staggering degree, 1977 production costs $29 per barrel compared with $36.60 for AB whereas in 1985 rose to $49.50 vs. $51.80 after expanding reach to 44 states. Main sources of competitive advantages are customer captivity, production advantages, and economies of scale, especially on a local level… HPQ vs. INTC. Box makers did not have high fixed cost/low marginal cost structure that gives rise to economies of scale. The component cost of the last machine to come off the line was not much lower than the first, and components accounted for most of the costs; rare to find economies of scale with cost structures like this. R&D costs were low. In years when INTC was spending 12% of sales on R&D, Compaq spent 4.5% and Dell 3.1%... Initial info. came from the retailers, who saw their inventory of Compaqs start to build. Lost competitive advantage and the resulting levels of profitability as the markets grew. When markets enlarge, they often allow competitors to achieve comparable economies of scale… On one hand, learning curve effects benefit a first mover as its variable costs decline with cumulative production volume. On the other hand, vintage effects-the fact that plants built later are more efficient than earlier ones- count against the first mover (Malone saw no need to move first b/c he knew had the scale; wanted tech adoption and profitability to be proven first). A company that makes life much better for its customers gets handsomely rewarded, provided it can separate itself from competitors offering similar benefits… Need to expense options (CSCO undoubtedly understated costs by keeping a large share of salary expenses off of Income Statement).  CSCO- 1996 op. margin below 20% for first time and R&D was 4.5%. Difference b/w enterprise MKT and service provider much greater than anticipated (expansion). Initial complexity (customers needed) diminishes over time. What matters in a market are DEFENSIBLE competitive advantages, which size and growth may actually undermine. Game theory: the outcome of any action by Lowe’s depends upon who Home Depot chooses to respond, and vice versa. It is naïve to think that the bottom line is everybody’s primary concern; always an incentive for individual competitors to deviate from ostensibly superior outcomes, but Lowe’s can announce that it will match whatever price HD offers… History of attempts to enter virgin territory has not been a happy one for either the first mover or its slightly later competitors, especially true in the case of unoccupied territories, which often turn out to be lawless frontiers… Airlines: newcomers not restricted by the expensive and restrictive labor contacts that had been the norm during the regulated period… If Nintendo persisted in trying to capture a disproportionate share of the industry profits, then its position would survive only so long as its competitive advantages were sustainable. Design and production of the game consoles exhibited few economies of scale. R&D costs were relatively low. Game writers who Nintendo bullied ultimately nearly destroyed them…. When management with a good reputation meets and industry with a bad reputation, it is the reputation of the industry that survives. Ill-conceived initiatives that ignore the structure of competitive advantage and competitive interactions is a leading cause of business failure. However, strategy is not the whole story. An obsession with strategy at the expense of the pursuit of operational excellence is equally damaging.