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
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
$15
Source: Compustat, Value Line, Marakon Associates Analysis
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Average Economic Profits in
the Drug Industry, 1978 -1996
ROE-Ke Spread
60%
SmithKline
40%
Glaxo
American
Amgen
Home
Products
Merck
20%
Schering Plough
Watson
Rhone-Poulenc
Mylan Labs
Bristol
Warner Lambert
Myers
Eli Lilly
Pfizer
Perrigo
Pharmacia & Upjohn
Forest Labs
Alza
0%
ICN
Scherer
Ivax
Genetech
Biogen
Roberts
Genzyme
Dura
Chiron
Cephalon
Gensia
Cygnus
Immunex
(20%)
(40%)
(60%)
Average Invested Equity ($B)
(80%)
$0
$5
$10
$15
$20
$25
$30
Source: Compustat, Value Line, Marakon Associates Analysis
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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
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 firm’s 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 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
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)
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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
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Porter’s 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
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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
average
competitor
1.
2.
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3.
13
Porter’s Generic Strategies
Low cost leadership
Differentiation
Dc
Ci
Cc
Di
Cc
Cc
Ci
Di
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
Learning
Pattern of capacity
utilization
Linkages
Interrelationships
Integration
Timing
Policies
Location
Institutional
factors
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
+
Differentiation
OR
Sometimes consistent
But requires defense
against a competitor
achieving one or the
other
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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”
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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
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
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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
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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
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
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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
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
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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
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
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