Chapter 3 Exhibits

1. Chapter 3 Exhibits from Strategy and the Business Landscape

2. 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 Cleveland-Cliffs Birmingham Quanex Lukens (10%) USX-US Steel ACME Metals Ampco Inland Steel (20%) Armco WHX Bethlehem Average Invested Equity ($B) (30%) $0 $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 $11 $12 $13 $14 $15 Source: Compustat, Value Line, Marakon Associates Analysis

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

4. Cost Analysis • Began with the Experience Curve • Focus on costs of doing business • Caused firms to begin disaggregating cost structures. • Value chain (McKinsey’s Business System) is developed. • Shared costs in large corporations required special treatment. • A interest in capacity utilization emerged.

5. Experience Curve for Semiconductor Memories 1976 100 1977 75 1978 50 1979 Price per bit (millicents) 25 1980 10 1981 1982 1983 1984 0.1 1.0 10 100 Cumulated output (bits x 1012) Source:Integrated Circuit Engineering Corporation

6. McKinsey’s Business System Technology Manufacturing Distribution Marketing Service Design Development Procurement Assembly Transport Inventory Retailing Advertising 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)

7. Differentiation Analysis • Experience curve recognized as relevant only to commodity industries. • Competitive analysis refocused on differentiation. • Value chain emerges in current form (Porter)

8. Value Chain for an Internet Start-Up Firm Infrastructure • Financing, legal support, accounting Human Resources • Recruiting, training, incentive system, employee feedback Technology Development • Inventory system • Site software • Pick & pack procedures • Site look & feel • Return procedures Support Activities • Customer research Procurement • CDs • Shipping • Computers • Telecom lines • Media • Shipping services • Inbound shipment of top titles • Server operations • Billing • Collections • Picking and shipment of top titles from warehouse • Shipment of other titles from third- party distributors • Pricing • Promotions • Advertising • Product information and reviews • Affiliations with other websites • Returned items • Customer feedback • Warehousing • Primary • activities Inbound Logistics Operations Outbound Logistics Marketing & Sales After-Sales Service Primary Activities

9. Cost vs Differentiation • Focus on both cost and differentiation • Porter proposes that there are only three kinds of strategies: • Differentiation • Overall cost leadership • Focus • This suggests that costs and differentiation are mutually exclusive. • Dual advantages are rare.

10. Porter’s Generic Strategies STRATEGIC ADVANTAGE Uniqueness Perceived by the Customer Low Cost Position OVERALL COST LEADERSHIP Industry wide DIFFERENTIATION STRATEGIC TARGET Particular Segment only FOCUS Source: Michael Porter, Competitive Strategy, 1980

11. Interplay between Cost and Differentiation $ Industry average competitor Successful differentiated competitor Successful low-cost competitor Competitor with dual advantage

12. Costs and Willingness to Pay for Aspartame Willingness to Pay 100 ( NS ) 90 ( HSC ) 80 70 60 50 40 30 $ per Lb. 20 10 0 0 2000 4000 6000 8000 ( HSC ) Cost ( NS ) Tons

13. Hostess’s Cost Components 80 Profit 70 Marketing: Promotions 60 Marketing: Advertising 50 Outbound logistics Cents per unit 40 Operations: Manufacturing 30 Operations: Packaging Operations: Ingredients 20 10 0

14. Relative Cost Analysis 90 80 Profit Marketing: Promotions 70 60 Marketing: Advertising 50 Outbound logistics 40 Operations: Manufacturing 30 Operations: Packaging 20 Operations: Ingredients 10 0 Cents per unit Hostess Little Debbie Ontario Baking Savory Pastries

15. Relative Success in Satisfying Customer Needs 4 3 Hostess Rating Little Debbie 2 Ontario Baking Savory Pastries 1 0 Price (****) Brand Image (****) Freshness (***) Variety (**) Size (*) Customer Need (and Importance ****)

16. Chapter 3 Text Related Slides from Strategy and the Business Landscape

17. Calibrating Profit Drivers Residual Industry Corporate Positioning Source: Richard P. Rumelt, “How Much Does Industry Matter?,” Strategic Management Journal, 1991; 12:167-185

18. Added Value • 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 Added value = total 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 world if the firm disappeared

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

20. Value Creation (cont.) Customer Firm Supplier Willingness to pay Total value created Supplier opportunity cost

21. Value Division Customer Firm Supplier Willingness to pay Value captured by customer Price Value captured by firm Cost Value captured by supplier Supplier opportunity cost

22. 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

23. Value Chain Firm Infrastructure Human Resource Management Technology Development Procurement Support Activities M a r g i n Inbound Logistics Operations Outbound Logistics Marketing & Sales After-Sales Service Primary Activities

24. Types of Competitive Advantage Lower Cost Differentiation Competitive Advantage

25. 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 parity or proximity in satisfying buyer needs • Cost leadership often requires trade-offs with differentiation

26. Successful Cost Leadership Strategy:Gallo Wines Firm Infrastructure Human Resource Management Technology Development Procurement Support Activities • Blending technology M • National advertising a • Grape purchasing r g i n Inbound Logistics Operations Outbound Logistics Marketing & Sales After-Sales Service Primary Activities

27. Scale Learning Pattern of capacity utilization Linkages Interrelationships Integration Timing Policies Location Institutional factors Cost Drivers Source: Michael E. Porter, Competitive Advantage (New York: Free Press, 1985)

28. 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

29. 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

30. Successful Differentiation Strategy:Stouffer’s Frozen Foods Support Activities Firm Infrastructure Human Resource Management Technology Development Procurement • Innovative menus • Sauce technology M a • High quality inputs r g i High quality, consistent packaging Brokers Highest advertising levels Advertising content n Inbound Logistics Operations Outbound Logistics Marketing & Sales Service Primary Activities

31. 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

32. 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

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

34. Types of Competitive Advantage Lower Cost Differentiation Competitive Advantage

35. 1. Catalog Activities (The Value Chain) Firm Infrastructure Human Resource Management Technology Development Procurement • Frugal culture (sharing hotel rooms, calling collect • No regional offices • Lots of management visits • Saturday meetings • Fun working environment • Associates, not employees • Not unionized • Store manager autonomy • Manager compensation tied to store • Stock ownership plan • Decentralized training in DC • Promotion from within • Associate compensation tied to company • Shrink incentive plan Support Activities • POS • Satellite system • Store performance tracking • UPC • Real-time market research M • Hard-nosed negotiating • Centralized buying • No-frills meeting rooms • Partnerships with some vendors • EFT, electronic invoicing • Planning packets a r g • Frequent replenishment • Automated DCs, cross docking, pick-to-light • EDI • Hub and spoke system • Big stores in small towns => local monopolies, low rental costs • Pricing that reflects local monopoly • Concentric expansion • Brand-name merchandise • Private labels • Little space for inventory • Suggestion program • Store within a store • Traiting: tailoring merchandise to locale • EDLP • Low prices • Store manager latitude on pricing • Little advertising • Merchandise meeting • Easy returns i n Inbound Logistics Operations Outbound Logistics Marketing & Sales After-Sales Service Primary Activities

36. 2. Use Activities to Analyze Relative Costs

37. 3. Use Activities to Analyze Relative WTP (****) (***) (**) (*) (****)

38. 4. Explore Options and Make Choices

39. Complementarities and Landscapes No Complementarities Complementarities

40. NK Modeling • N is the number of activities about which choices have to be made • K is the degree of interactivity in the payoffs to them • Each of the N activities makes a randomly assigned contribution to overall value that depends on how that activity and K other activities are performed

41. Activities, Interactivity and Peaks Source: Jan W. Rivkin

42. How Far Can a Competitive Advantage Travel? • Is the destination market structurally attractive? • After considering the effects of entry • Does the advantage apply in the destination market? • A formula for success in one market can be a recipe for disaster in another • Strategy is highly dependent on context • Can the advantage be transferred? • The very factors that block imitation at home may prevent transfer to the destination (e.g., resources or capabilities build up over a long period) • Transfer may take a long time • Do the benefits of transfer outweigh the costs? • Including benefits and costs to home business

43. The Importance Of Uniqueness • Uniqueness is essential to adding value in both competitive and complementary situations • The kind of strategy that is uniquely valuable tends to involve • External consistency, with the environment • Internal consistency • Dynamic consistency, in the sense of deliberate upgrading

44. The Limits of Positioning Analysis • Evaluates competitive positions under simplifying assumptions • Ignores differential reactions • sustainability analysis recognizes that superior positions are like honey to flies • Ignores uncertainty • flexibility analysis recognizes that revision possibilities are valuable in an uncertain world

45. Ethylene Positioning Analysis • Relative costs of new plants • New plants vs. old plants • Average industry margin

46. Profits from a New Ethylene Plant Client’s cost advantage at adding a new plant • Cost advantage of new plants vs. “average” capacity • Average industry profit margin • Profit margin attainable from plant addition

47. Analytical Components

48. Potential Volatility OPEC Politicization Exchange Rates Greater Number Less Chemical Co. Control Greater Asymmetry oil companies foreigners cos. from mature industries History of losses Average Industry Margin1990s vs. 1960s Feedstock Suppliers Competitors Buyers • Maturing Demand • Better Info About Price Dispersions

49. New Plants vs. Old Plants Cost Capital Cost Old Plants Cash Cost Cumulative Capacity

50. Relative Costs of New Plants [ ] Competitor’s Capital Cost Competitor’s Capacity Util. Client’s Capital Cost Client’s Capacity Util. x ROR • Client had traditionally maintained higher-than-average capacity utilization • The scale it was planning to build at was only one-half to one-third of likely competitive expansions • Plant scale had big impact on capital costs • = -