Strategies for Staying Cost Competitive - Harvard Business ...

He recommends that managers do a strategic cost analysis to identify the severity of ... with low-cost producers in a position to take business away from ... Youhave1freearticlesleftthismonth. Youarereadingyourlastfreearticleforthismonth. Subscribeforunlimitedaccess. Createanaccounttoread2more. Competitivestrategy StrategiesforStayingCostCompetitive Nocompanycantotallyavoidtheimpactofincreasingcosts.Andmostmanagershavelearnedtoadjusttotheeffectinflationhasoncurrentoperatingcosts.Butfewhavefactoreditintotheircompetitivestrategies.Andmostmanagers,particularlythoseincapital-intensiveindustries,havenotpaidenoughattentiontothewayincreasingcapitalrequirementsaffect[…] by ArthurA.Thompson,Jr. by ArthurA.Thompson,Jr. FromtheMagazine(January1984) Tweet Post Share Save GetPDF BuyCopies Print Tweet Post Share Save GetPDF BuyCopies Print Leerenespañol Leremportuguês Nocompanycantotallyavoidtheimpactofincreasingcosts.Andmostmanagershavelearnedtoadjusttotheeffectinflationhasoncurrentoperatingcosts.Butfewhavefactoreditintotheircompetitivestrategies.Andmostmanagers,particularlythoseincapital-intensiveindustries,havenotpaidenoughattentiontothewayincreasingcapitalrequirementsaffecttheirabilitytocompeteinthelongrun. Asaresultofresearchandconsultingworkhehasdonewithanumberofcapital-intensivecompanies,thisauthorthinksthatanyorganizationcanbetteritsstrategicpositiondespite,andevenbecauseof,inflation.Herecommendsthatmanagersdoastrategiccostanalysistoidentifytheseverityoftheimpactofinflationontheircompanies’competitivepositions,aswellasonthepositionsofrivalcompanies.Inthisarticle,hetakesthereaderstepbystepthroughadiagnosisandanalysisofchangingcostpatternsaswellasthroughtheformulationofastrategicsolution. Duringyearsofchronicinflation,themanagersofXYZCorporationdevelopedthehabitofraisingpricestocoverrisingcostsanddefendprofitmargins.(XYZisanameIamusingtodesignateacompositeofseveralcompanies.)Observingthatallitsrivalswereforcedtodothesame,XYZfeltsecureinitsstrategy. Thendeflationbegan,marketdemandslackened,andadeeprecessionsetin.Abuyers’marketemerged.XYZcouldn’tcountonpricehikestocoveritsstillslowlyrisingcostsbecauseitsvolume-consciousrivalswereaggressivelyusingpriceasaweapontogainmarketshare.XYZ’sprofitserodedwhiletheothers’remainedbuoyant.Toaddinsulttoinjury,XYZ’srivalsnolongerwentalongwithindustrywidepriceincreases;evenwhensuchhikesbecametimely,theothercompaniesraisedtheirpricesbyasmallerpercentagethanXYZordelayedthemaltogether. XYZwascaughtsquarelyinacompetitivepricingtrap.Thecompany’smanagersbelievedthatcompetitorsheldacostadvantage.Tocatchup,theyconsideredinvestmenttomodernizeexistingfacilitiesortobuildnewcost-competitiveplants.ButthecapitalinvestmentcostsforsuchconstructionweresohighthatXYZcouldexpecttoearnanattractivereturnonitsinvestmentonlybysellingproductsatpriceswellabovethegoinglevel—pricesthatitsrivalscouldcontinuetoundercut. XYZ’spredicamentissharedbycompaniesinmanycapital-intensiveindustries.IntheNorthAmericanpulpandpaperindustry,a$100pertonproductioncostdifferenceexistsbetweenhigher-costnewfacilitiesandlesscostly,fullydepreciatedmills.1 ManyU.S.steelcompanieshaveseentheirvariableoperatingcostsrisemorequicklythanthoseofAsianproducers,andthecapitalcostsofmodernizinglarge,integratedmillsseemprohibitive. Onceasecuregeographicmonopoly—andessentiallyacommoditybusiness—theelectricutilityindustryisnowinthethroesofpricewarfareinthewholesaleandbulkpowermarketsegments,withlow-costproducersinapositiontotakebusinessawayfromhigher-costsuppliers.Nearlyeveryelectricutilitythatisconstructingnuclearpowerstationstomeetfuturegeneratingneedsisbeingsqueezedbyescalatingcapitalcostsandamarketplacerepletewithgeneratingcapacity.Anumberofpowercompanies,increasinggeneratingcapacityatcapitalcoststhreetofivetimeshigherthanthoseforfacilitiesbroughtoninthe1970s,arenervousaboutwhetherthehighfixed-costchargesforthesenewfacilitieswillallowthemtobepricecompetitivewithotherelectricenergysuppliers. Forexample,theCanadiansurplusofcheaphydroelectricpowerandNewEngland’s30%electricitysurplusthreatentheoncesoundeconomicsofNewHampshire’sSeabrooknuclearproject(whoseoriginalestimatedpricetagof$1billionforunits1and2hasballoonedto$5.2billion).Inthesameway,asurplusofgeneratingcapacityinthePacificNorth-west,exacerbatedbyprojectedrateincreasesof100%to200%,hasbroughttheoncestrongWashingtonPublicPowerSupplySystemtobonddefaultandeventothebrinkofbankruptcy.Thefutureholdsevenmorecompetitivepricingthreats;apotentialbreakthroughinthedevelopmentofsolarthermalequipmentandphotovoltaiccellsbyGeneralElectric,Westinghouse,UnitedTechnologies,andseveralJapanesecompaniesportendsimportantnewsourcesofevenlower-costenergysubstitutes. Ofcourse,somecompaniesdidmanageinthe1970stoavoidinflation’strapbyinvesting“early”innewfacilitiesandprotectingtheirlong-runcompetitiveposition.BothSunOilandIBMhavebenefitedfromcommittinginvestmentcapitalonatimelybasistostrategicmovesdesignedtoyieldstrongcostpositionsvis-à-vistheircompetitors. AcompanythatfindsitselfinatraplikeXYZ’scandosomethingtogetoutofit.Frommyresearchandworkwithcompaniesfacingsharplyrisingcapitalrequirements,I’veseenthevalueofdoingstrategiccostanalysistoidentifywaystodefendagainst,andsometimesescape,acompetitivepricingtrap. StrategicCostAnalysis Becauseinflationaffectseachcompanyinanindustrydifferently,thefirststepistodiagnoseyourchangingcosteconomicsallthewayfromtherawmaterialsstagetothefinalpricepaidbytheultimateconsumer.Thisinvolvesconstructingavaluechain,adiagramthatshowsthevalueaddedateachstepinthewholemarketprocessandexposesshiftingcostcomponents.Next,youassessthelong-runshiftsinthecostpositionofyourcompetitorsrelativetoyourown.Finally,youfactortheimplicationoffutureinflationintoyourowncostsandthoseofthecompetition. Thiskindofanalysisprovidesthebackdropforformulatinganeffectivestrategyanddefensetohelpyouavoid(orescapefrom)thecompetitivepricingtrap,whetheryouwanttobecomethelow-costproducerintheindustry,focusyoursaleseffortsonaparticularsegmentofthemarket,ordifferentiateyourproductfromyourcompetitors’. Identifyingshiftsinkeycostcomponents Sustainedinflationleavesanimprintoncurrentoperatingcostsaswellasonthecostoffixedassetsandnewcapacity.Nooperatingcomponentremainsunmarked,whetherpurchasedmaterials,directlaborcosts,maintenance,energy,salaries,fringebenefits,transportation,marketing,ordistributioncosts.Uncheckedinflationcanradicallychangethewholecoststructureofanentireindustry.Afteradjustingforgreatersalesvolume,forexample,operatingcostsinelectricutilitiesroseanaverageof$4billioneachyearbetween1970and1981.That’sinanindustrythatstartedfromabaseof$20billioninsalesand$3billioninnetincome.The$44billionincreaseover11yearsspawnedroundafterroundofrateincreases,pushingratesin1982some200%to300%higherthanin1970.Customersbecamesopricesensitivethattheycuttheiruseofelectricityandaverageloadsfromarapidannual6%to8%growthratedowntoamatureindustryrateof1%to3%. Moresignificant,however,ishowthephenomenonofrisingcostscan,overtime,producestrategicallyrelevantshiftsinacompany’scoststructureandcostcompetitiveness.Tobeginwith,companiesusuallyexperienceadifferentrateandpatternofcostchangeforeachcostcomponent.Duringthe1970s,theannualcostincreasesforBritishSteel’skeycomponentsroseaslittleas8%toasmuchas24%,andtheyear-to-yearpatternsfromcomponenttocomponentfluctuatedmarkedly.2 ThiskindofcostdifferentialhelpedreversetheinternationaladvantageU.S.steelproducersoncehad.In1956,theycouldproduceatonofcold-rolledsheetsteelfor$35lessthantheJapanese.By1976,Japanesecompanieswereproducingatonfor$35lessthantheirAmericancompetitors.3 Becauseeverycompanywithinanindustryhasaslightlydifferentcoststructureformanufacturinginputs,variedinflationratesfortheseinputscanopenupimportantcostdifferentialsbetweencompetitors.Takethecaseofenergyfuels.Pricepatternsacrossfueltypeshavevariedwidelyfromfuelsourcetofuelsourceandfromyeartoyear.In1976,thepriceofgasfuelswentup35.2%,whilethatofcrudepetroleumincreasedonly8%.In1981,however,thepriceofcrudeshotup44.4%,whiletheriseingaspriceswasonly23.5%.Suchdifferencesininflationratesforparticularcostcomponentsplayabiglong-termroleinshiftingthecostcompetitivenessofdifferentfuelsourcesandenergy-intensiveindustrialcompanies.Intheelectricutilityindustry,wherefuelcostsaccountfor40to60%ofoperatingexpenses,eachpowercompanyhasexperiencedadifferentnetinflationaryimpact,dependingontheparticularmixofcoal,fueloil,naturalgas,nuclearpower,andhydroelectricgeneration.Variationsinfuelcosts,alongwithdifferencesincapitalconstructionneeds,havedrivenbigwedgesbetweentherateschargedforelectricpoweracrosstheUnitedStates. Manufacturingcompaniesinsuchenergy-intensiveindustriesaspulpandpaper,chemicals,andprimarymetalsfeelthecompetitiveimpactoffuelcostdifferences.AnaluminumproducerwithplantfacilitiesinthePacificNorthwesttodaycanmanufacturemorealuminumwithfewerdollarsthanaproducerintheMidwest. Inflation,ofcourse,raisestheconstructioncostsofnewfacilities,thepricesofnewequipment,thecostofequityanddebtcapital,andtheneededamountofworkingcapital.Increasingcapitalcostscanpushtheincrementalcostsoffixedassetsandcapacityfarabovethehistoriccostofexistingplantandequipment.Inturn,averagecostsrisesharplyasnewcapitalinvestmentsaremadeandcauseasqueezeonprofitmarginsandaneedtoraisesellingprices.Moreover,thesizeoftheincreaseincapitalrequirementscanimposeaseverefinancialburden. VirginiaElectricandPowerCompany,forexample,willmothballanuclearpowerplant,despitea$540millioninitialinvestment,becausetheestimatedfinalpricetaghasrisenfrom$1.2billionto$5.1billion.Long-termcontractingforcoal-firedgeneratingcapacityfromneighboringutilitiesisnowmoreeconomical. ThecapitalcostsforanewsteelmillintheUnitedStateshaveescalatedtoaboutninetimesthecostoftheembeddedtechnology.4Whileproductioncostsfornewplantshavedropped$60perton(becausetheamountoflaborandenergynecessarytoproduceatonhasdropped),thecapitalcostsforanewmillare$130pertonhigherandpushunitcostsupanet$70,or10%abovethemarketpricepertonofsteel.Asaresult,steelcompaniesmusteitherrefurbishtheirinefficientmillsorclosethemdown. Capitalcostscanrisebecauseofunforeseendifficultieswithexpandingoperations.SouthlandCorporationsawitscostsfornew7–Elevenconveniencefoodstoresrisebecauseoftheexplosionintheindustry.WhenSouthlandfirstboughtsitesinthe1960s,fewothercompanieswerecompetingforthekindoflocationitneeded.Withtheriseinthenumberoffastretailoperations,otherfastfoodchains,servicestations,andretailcompaniesbegantocompeteforthesamelocationsandthusdroveuptheirprices. Giventherealisticprobabilitythatrisingoperatingandcapitalcostswillaffecteachcompetingcompanyinadifferentway,itisimportantforeachcompanytoprobethenatureandsizeofthedifferencesinordertounderstandthepotentialshiftincompetitiveadvantage.Thisiswhereavaluechaincomesin. Usingavaluechain Acompanycanshowthemakeupofcostsallthewayfromtherawmaterialsphasetotheendpricepaidbytheultimatecustomeronavaluechain(seeExhibitI).5Strategiccostanalysiscannotberestrictedtoone’sowninternalcostsbecauseeconomywideinflationoftenaffectssuppliersanddistributionchannels.Byincludingtheimpactofcostsbothinsideandoutsidethecompany,thevaluechainhelpsthemanagerunderstandthesumtotaloftheshiftingcosteconomiesupanddownthewholemarketspectrum. ExhibitIThevaluechain Thevaluechainisrevealingbutnotsimple.Touseit,acompanymustrecastitsownhistoricalcostaccountingdataintotheprincipalcostcategoriesthateventuallymakeupthevalueofitsproduct.Mostdifficultisthenecessityofestimatingthesamecostelementsforitsrivals—anadvancedstageintheartofcompetitiveintelligence. Despitethetediousnessofthisjob,thevaluechainpaysoffbyexposingthecostcompetitivenessofyourpositionandtheattendantstrategicalternatives.ExhibitIIshowsasimplifiedvaluechaincomparisonoftheshiftingcostsandcompetitiveadvantagebetweenU.S.andJapanesesteelproducersfrom1956to1976.Theshiftsintheseveralcostcomponentsaredramatic.Themajorcausesoftheshiftincostcompetitivenessinvolveddifferinginflationratesinthepricesforproductioninputs,buttechnologicalchangesandhigherJapaneselaborproductivityalsoworkedagainsttheUnitedStates. ExhibitIIValuechainsforU.S.andJapanesesteelcompanies:acomparisonbetween1956and1976Source:CompiledfromdataintheU.S.FederalTradeCommission,TheUnitedStatesSteelIndustryanditsInternationalRivals:TrendsandFactorsDeterminingInternationalCompetitiveness(Washington,D.C.:U.S.GovernmentPrintingOffice,1978)andinRobertW.Crandall,TheU.S.SteelIndustryinRecurrentCrisis(Washington,D.C.:TheBrookingsInstitution,1981). Plainly,thechain’smakeupwillvaryfromcompanytocompanyaswellasfrombusinesssegmenttobusinesssegment(productline,customertype,geographicarea,ordistributionchannel).Althoughitmakessensetostartwithavaluechainforawholebusiness,searchingforvariationsbysegmentcanrevealimportantdifferencesineachproduct’scostcompetitivenessandthecompany’sunwittingcross-subsidyofunprofitableproducts. Toillustratethestrategicpayoffofconstructingavaluechain,lookagainatExhibitI.Arelativecostshiftcanoccurinanyoneofthreemainareas—suppliers,thecompany’sownsegment,orforwardchannels.Afterconstructingavaluechain,acompanymaydiscoveritcanreestablishcostcompetitivenessonlyifitgoesoutsidein-houseoperations.Forexample,ifit’slosingoutbecauseofacompetitivedisadvantageinthecostofpurchasedinputs,thecompany’sstrategicoptionsaretonegotiatewithsuppliersformorefavorableprices,integratebackwardtogaincontrolovermaterialcosts,uselower-pricedsubstituteinputs,ormakeupthedifferencebyinitiatingcostsavingselsewhereinthetotalvaluechain. Whenthecostdisadvantageisindistribution,thecompanycanpushformorefavorableterms,changetomoreeconomicaldistribution,ormakeupthedifferencebyinitiatingcostsavingsearlierinthetotalvaluechain.Itislikely,ofcourse,thatasubstantialportionofanycostdisadvantageacompanyhaslieswithinitsownin-housecoststructure.Herethestrategyoptionsaremorecomplex.Oneanalyticalapproachistocompareyourowncoststructurewiththatofyourrivalstodiscoverwhohasbeenmostaffectedbyoperatingcostandcapitalcostchanges.Forexample,ifbothyouroperatingandyourcapitalcostsarehigherthanthoseofcompetitors,you’reabouttobecaughtinthepricingtrap.Youmayfindithardtoholdontoyourshareofthemarketand,moreimportant,youprobablycan’tinvestyourwayoutofthecostdisadvantageintheshortrun(becausethenewcapitalrequirementsareunattractivelyhighandleavenoroomforareturnoninvestmentatgoingmarketpricesfortheproduct). Attheotherendofthespectrum,whereyourcompanyislessaffectedbybothrelativeoperatingandcapitalcostincreases,youareinanexcellentpositiontouseyourlow-coststancetowinahighermarketsharebyofferingalowerprice.Companiesinthemiddle(eithermoreorlessaffectedbytwovariables)havelessclear-cutstrategies.Onlyadetailedanalysiswillrevealthetrade-offsbetweenhigherandlowercapitalcostsandlowerandhigheroperatingcostsandwhattodoaboutthem. Assessingcompetitiveshifts Inthenextphaseofstrategiccostanalysis,thecompanyhastoassesshowrisingcostpressureswillaffectitsgrowthobjectivesandmarketsharepotential.Forthesakeofsimplicity,let’sconsiderthreebasicstrategicposturesrelatingtogrowth:buildingmarketshare,defendingthecurrentmarketshare,orgivingupmarketshare(takinga“shrinkabandon”approach).Furthermore,let’sfocustheanalysisontheextremes,whereinflationdrivesupeitheroperatingcostsorcapitalcosts. Ifallcompetitorsfeelthesameinflationaryimpactonoperatingcostsbutthefixedasset-capacitycostincreasesthattheysufferfromdiffergreatly,thenan“investandgrow”strategytobuildmarketsharecanworktotheadvantageofacompany,provideditinvestsearlyinnewcapacity.Eventuallyitwillenjoylowerfixedcoststhancompetitorsthataddcapacitylater,wheninvestmentcostsarehigher.Itmustalsoforecastfuturemarketvolumeaccuratelyandtargetitsmarketshareobjectivestocoincidewitharelativelylower-costindustryposition. Ifthetablesareturnedandinflationhitsoperatingcostsunevenlywhilecapitalcostsremainequal,acompanycanprotectcostcompetitivenessifit:(1)innovatesaroundtroublesomeoperatingcostcomponentsasnewinvestmentsaremadeinplantandequipment,(2)translatestheresultingcostadvantageintoagaininmarketshare,or(3)offsetsanyincreasesinoperatingcoststhatdoarisewithnewefficienciesassociatedwithaddedsalesvolumeandhighermarketshare. Ifthesourceofrisingunitcostsinanindustrycomesmainlyfromtheaddedcostsofnewinvestmentsinplantandequipment,a“holdshare”growthobjectivecanyieldattractiveprofitmargins.Companiesthatdon’tbuildnewplantscangainacompetitiveadvantageiftheyareabletouseahigherpercentageofexistingcapacitytoproducetheextravolumeneededtomaintainmarketshare.Thisholdsharestrategycanworkunderconditionsofstrongorweakmarketdemand.Inaslackmarket,low-costcompaniesareinthepositiontouseaprice-cuttingstrategytoprotecttheirsalesvolumeandpreservecapacityutilization.Whenmarketdemandisstrong,thecompanycangoalongwiththepriceincreasesthatmoregrowth-mindedcompaniesneedtocovertheincrementalunitcostsassociatedwithnewinvestmentsinplantandequipment. Interestinglyenough,acompanywithalong-termshrink-abandonstrategymaybeabletobenefithandsomelyfromsharplyrisingcostsfornewplantsandequipment.Becauseitiscommittedtocost-containingretrenchmentandwon’tencountercapacity-inducedcostincreases,acompanycansimplysellunderthepriceumbrellaofrivalsandenjoyalong“cashharvest”ascompetitorsraisepricestocompensateforthehighercostsassociatedwithcapacityexpansionorcapacityreplacement. Assessingfuturecostincreases Inthefinalanalyticstep,acompanyturnstotheimpactoffuturecostincreasesonboththeoperatingandthecapitalsideoftheproductionequation.Forexample,ifacompanyseemslikelytosufferfrombothhighoperatingandhighcapitalcosts,itwillhavetoincreasepricesatratesfasterthaninflationtoholditsmarket,butitwillsooninvitecustomerstoswitchtosubstitutes.Itwillhavetoconsidertheoptiontoharvestordivestunlesstheindustry’sgrowthprospectsarebullishdespiteinflation,orunlesstheindustryhasanimmaturetechnologyand“breakthroughs”cantakeawaysomesourcesofrisingcosts. Iftheinflationarycombinationresultsinacompanyexpectinghigherrelativecapitalcostsbutloweroperatingcostsandifitsindustryhasgoodgrowthprospectsandamaturetechnology,thenthereisapotentialfirst-moveradvantagefromaddingnewcapacityearly.Tosustaintheadvantage,itmustbeabletorecoupthecostsufferedfromtemporaryexcesscapacitywhenrivalsfinallyaddorreplaceplantandequipmentatinflatedcosts.Thesizeofanyfirst-moveradvantagedependsonthespeedofincreasesincapitalrequirements,theextentoftheindustry’sneedtoaddcapacitytomeetnewmarketdemand,andthepotentialforlower-costsubstitutestocapturealucrativeshareofthemarket.Whendemandisexpectedtoremainslack,thebestpositiontodefendisahold-sharestrategy,inwhichlong-termcostcompetitivenessisprotectedbykeepingnewinvestmentsinfixedassetstoaminimum. Obviously,companiesthatexpecthighfutureoperatingandlowcapitalcostincreasesandcompaniesthatanticipatelowinflationinbothtypesofcostshaveagreaterdegreeofstrategicfreedom.Inneithercasedocompanieshavetoworrysomuchaboutthetimingofdecisionstoaddorreplaceproductionfacilities.Theirriskoffallingintothepricingtrapislower,andtheyaremoresecureinraisingpriceswhenshort-runcostchangessqueezeprofits.Abuild-sharegrowthstrategybyonecompanycancoexistwithahold-sharestrategybyanother. AtIBM,topmanagementdecidedthattheeconomicimpactofrisingoperatingcostswouldoutweighthatofescalatingcapitalcosts.Thecompanymadeabigcommitmenttocapitalspending.JohnR.Opel,IBM’sCEO,oncesaid,“Wewanttobethelowest-costproducerofeverythingwemake.Andwenowexpecttobeginrealizingtheproductivitygains…madepossiblebyoursizableinvestments.”6TheinvestmentmoveallowsIBMtotaketheoffensivewithitspricingstrategy. FactoringinCostEconomies Whetheryouexpectyourcompany’scoststobeaffectedmorebyoperatingcostchangesorbycapitalcostchangesalsodeterminesthesuccessofyourcompetitivestrategy.Forexample,ifyouwanttobethelow-costproducerinthemarketbutyouanticipaterisingcapitalcostsasamajorproblem,yourcompany’sbestbetiseithertobuildearly(ifdemandprojectionsarebullish)ornottobuildnewplantsatall(ifthemarketismature).Eitherway,youlockintoalow-costpositionwithfewerdollarsoffixedassetinvestment.Then,giventhecapacityyouhave,youtrytoproduceatratesclosetopracticalcapacityinordertoenhancetherevenueproductivityofyourfixedinvestment. Therearesomeconstraintsonthisstrategy.Youwillhavetoadjustif,whilepushingcapacitytothelimit,youfindoperatingcostsbeginningtocreepup.Anotherproblemmayariseifyouhavetocutpricestopreservevolume;inthatcase,youwon’tbeabletousefullcapacity. Nonetheless,ifyourbusinesshasrelativelyhighandrisingfixedcostsperunit,successfulcostleadershipdependsonthecombination—andtiming—oflowcapitalinvestmentandproductiveuseoffixedassets.Thekeycostdriversarethetimingofcapacityadditionsandinvestmentandcapacityuse.Manyelectricutilityexecutiveshavebeguntopushtheuseofthisapproach. Differentiatewithatwist Risingcapitalcostswillhityourcompanyhardifyourelyonadifferentiationstrategytowinmarketshare.Therearelimitstohowmuchmorebuyerswillpayforaproductthatisfancierthanitsrivals’.Atsomepoint,thebuyersmaybeattractedtoamoregenericproductatalowerprice.Thekeyistocontainnewspendingcommitmentsthatareaffectedbyrisingcapitalcosts.Youmusttry,insofarasyoucan,toshiftthebasisofyourdifferentiationtooperatingcostvariables—toadvertising,service,inspectionprocedures,andmanufacturingworkmanship.Ifthatisimpossibleandyoumustcontinuetobasethestrategyonthebetterperformanceofyourproduct,thenyoumustmakecertainthatthecoststobuythenewplantandequipmentnecessarytomakeyourproductthebetterperformercanbeoffsetbyperformancegainsthatwillpreserveyourbuyers’preferenceforyourproductandforestalltheirnaturalmotivationtoswitchtoalower-costsubstitute.Otherwise,astrategytobethecostleaderwillbeataperformance-baseddifferentiationstrategy. Focusonaparticularsegment Inanindustrywherenewfixedassetsorcapacityadditionsareexpensive,acompanywithrelativelymodernfacilitiesandadequatecapacitymaywellfinditcompetitivelyadvantageoustouseafocusstrategyandconcentrateonselectedgroupsofbuyers.Anarrowcustomerbasehelpslimittheneedforcapacityexpansionandshieldsthecompanyfromthecostofescalatingcapitalrequirements.Bynarrowingtheproductline,thecompanycanallocateexpensiveproductioncapacitytoitsmostattractiveitemsandmarketsegments.Highermarginscanbeexpectedbothfromhavingafavorablecostpositionandfrom“tradingup”theuseofexistingcapacity.Suchfocusdirectscorporateattentiontothebestuseofexistingcapacityandhasatightstrategicfitwiththeeconomicneedtoenhancetherevenueproductivityofexpensivecapitalassets. TheOperatingSide Whenrisingcostshittheoperating-costsideofthevaluechainharderthanthecapitalside,acompanycanstillbesuccessfulinpursuingastrategyofbeingthelow-costproducerifitcanfindwaystoinnovatearoundthecomponentsofoperatingcostsmostsusceptibletoinflation.Itcanalsotrytorestructurethewholevaluechainbysubstitutingitsowndistributionnetworksfordealersandfranchises. Petroleumrefiningprovidesaninterestingexampleofhowtodefendagainstlong-termpriceincreasesinakeyresourceinput.Since1975,U.S.oilcompanieshaveinvested$15billiontoupgraderefineriessothattheycanusecheaper,moreplentifullow-qualitycrudeoil.Theinvestmentisexpectedtopayagoodreturnthroughtheuseoflower-costcrudeoilandimprovedrefiningtechnologytoincreasetheyieldsofhigher-marginproducts. AshlandOilfiguresitwillreducerawmaterialscostsby20%to25%througha$240millionupgradingofitsrefineries.Makingthesekindsofinvestments“early”canmeanmajorsavingsincapitalcosts;StandardOilofCalifornia,whichspent$1.3billiontoupgradeitsPascagoula,Mississippirefineryin1981and1982,hasestimatedthatthesameimprovementwouldhavecost$2billionin1983. Incounteringthesestrategies,theSunCompanydecidednottoupgradeitsPennsylvaniarefineryandgambledthattheindustry’sshifttolow-qualitycrudewouldleaveSunampleaccesstohigh-qualitycrudeandthatthepricedifferencebetweenhigh-qualitycrudeandlow-qualitycrudewouldnotaveragethe$6to$7perbarrelthattheothercompanieshadusedtojustifytheirinvestments. Thesuccessofdifferentiationstrategiesinanenvironmentofrapidlyrisingoperatingcostsvariesaccordingtothebasisfordifferentiation.Themostthreatenedarethose“quality”and“service”typesofdifferentiationstrategiesthatrequireskilledcraftsmanship,highlaborcontent,customizeddesign,elaboratemarketinganddistributionnetworks,andpersonalizedextras—thecostsofwhichriseatabove-averagerates.Lessvulnerablearecompaniesthat(1)differentiateinpartsofthevaluechainlessaffectedbycosts,(2)catertoprice-insensitivebuyers,or(3)enhancethevalueoftheirdifferentiationfeaturesenoughtooutruntheeffectsofhigherunitcosts. Adifferentiationstrategybasedontheintangiblesofimage,buyerconfidence,andbrandrecognitionhasastrongerchanceofbeingsuccessfulwhenthecostsofcreatingormaintainingtheintangiblesarenotgreatlyaffectedbytheforcesofrisingoperatingcosts.Thekeyistofindcost-competitivewaystopreservethevalueofdifferentiationforthebuyerandtocontaincustomerswitchingbyofferinglowerprices.Anotherstrategicoptionistotrytoshiftmoreofthebasisfordifferentiationtoaspectsofproductperformancethatcanbeaddedbyinvestmentsintechnologyandfixedassets.Suchamovemayproduceadurablecompetitiveedge,especiallyifitcatchescompetitorsbysurprise. Whenoperatingcostsspiralupwardfasterthanthecostsofplantandequipment,afocusstrategycansucceedifthecompanyeitherconcentratesonbuyergroupsthatarelesspricesensitiveortriestobuilditsproductlinearounditemsthatareleastaffectedbycostchanges. StrategicRealignment Themajorlessoninstrategyformulationthatemergesfromthisanalysisisthatacompanymustcloselygearitsstrategytothelong-termchangesintheindustry’scosteconomics.Managersmustthinkstrategicallyaboutthelong-runimplicationsofshort-runcostincreasesandbecreativeinfindingwaystocaptureacompetitiveadvantagebyminimizingtheeffectsofinflationarycostpressuresonthecompany’sstrategy. Whilethereisnothinginherentlywronginmakingaseriesofshort-runpricingchangestocoverchronicallyrisingcosts,thefatalmistakeistofailtorecognizewhyandhowstrategymustdealwithalmostcertainlyunevencostchangesamongrivalcompanies.Thoughsmallatfirst,thecostdisparitiesthatemergecanovertimecreatebigshiftsincostcompetitivenessandcompetitiveadvantage. Avoidingpricingtrapsrequiresastrategicviewofthepresentcoststructure,ofhowthestructurechanges,andoftheimplicationsforgainingasustainablecompetitiveadvantage.Successcomestoacompanythataccentuateslong-termstrategicpositioning. Inflation:WhoGetsHurt? Liketheweather,inflationisaloteasiertotalkaboutthantodosomethingabout… Inmyjudgment,theimpactofinflationonbalancesheetsisconsiderablymoreseriousthanthatonincomestatements.Inthefirstplace,inflationdeprivespeopleoftheopportunitytosaveinaformthatgivesthemapredictablecommandoverfutureconsumptiongoods.Inanoninflationaryenvironment,peoplecanacquirevariousliquidassets,earnareasonablereturnonthem,andcountonthemasthemeanstoacquireabasketofconsumergoodsintheeventofespeciallylargeneedsordeclinesinincome.Tobesure,theycannevergetaguaranteeoffuturetuitioncosts,ortheprospectivepricetagontheirretirementhome,orchargesforlargemedicalneeds.Buttheserisksaremuchlessseriousthanthoseassociatedwithgeneralinflation. Whenover-allpricesarerisingrapidly,theirexactcourseisboundtobeunpredictable.Ifweallknewthat4percentayearinflationwouldlastthroughthenextdecade,nominalinterestrateswouldprobablybecomeadjustedtolevelsofferingareasonablerealreturn,andpeoplewouldknowhowmuchofaconsumermarketbaskettheirsavingsaccountscouldcommandin1980.Buttheresimplycan’tbegreatconfidencethatthepricelevelwillrisesteadilyatanysubstantialrate,suchas4percent.OnlyiftheGovernmentiscommittedtolimittherisetoacreepofnotmuchabove2percentcantherebereasonablepredictability. Theopportunityforsafesavingislostinaperiodofsizableandunpredictablepriceincreases.Someassetsofferadegreeofprotectionagainstinflationinthesensethattheirvaluesarelikelytomoveupasconsumerpricesrise.Butnoassetshowsagoodyear-by-yearcorrelationwithprices;evencorporateequitiesandrealestatearenotgoodanti-inflationaryhedgesbythistest.Theymayactuallytendtooutpacethepricelevelontheaverageinthelongrun,butonlywithwideswingsandgreatuncertainty. From:EconomicsforPolicymaking,SelectedEssaysofArthurM.Okun,ed.JosephA.Pechman(Cambridge,Mass.:TheMITPress,1983),pp.3,12–13;©1970byNewYorkUniversityPress.Reprintedwiththepermissionofthepublisher. References 1.PulpandPaper,August1982,p.133. 2.SeeR.A.Bryer,T.I.Brignall,andA.R.Maunders,AccountingforBritishSteel(Aldershot,England,Gower,1982),p.124. 3.RobertW.Crandall,TheU.S.SteelIndustryinRecurrentCrisis(Washington,D.C.TheBrookingsInstitution,1981),p.173. 4.Ibid.,pp.73and86. 5.TheconceptofvaluechainsisdiscussedandanalyzedinMichaelE.PorterandJohnR.Wells,“StrategicCostAnalysis,”unpublishedworkingpaper,HarvardBusinessSchool,1982. 6.“IBM:TheGiantPutsItAllTogether,”Dun’sBusinessMonth.December1982,p.56. AversionofthisarticleappearedintheJanuary1984issueofHarvardBusinessReview. ReadmoreonCompetitivestrategy orrelatedtopics Costing, Financeandinvesting andPricingstrategy AT Mr.ThompsonistheJohnR.MillerProfessorofBusinessAdministrationattheUniversityofAlabama,wherehespecializesinstrategicmanagement,competitionanalysis,andtheeconomicsofthecorporation.Hehaswrittenninebooksandpublishedarticlesinmorethan20professionalandtradejournals.ThisisthefirstarticlehehaswrittenforHBR. Tweet Post Share Save GetPDF BuyCopies Print ReadmoreonCompetitivestrategy orrelatedtopics Costing, Financeandinvesting andPricingstrategy PartnerCenter Diversity Latest Magazine Ascend Topics Podcasts Video Store TheBigIdea Data&Visuals CaseSelections