Monday, December 29, 2008

Industry Capacity Expansion Despite Overcapacity

The global automobile industry is in world-wide overcapacity. In 2006, the industry had the capacity to build 80 million vehicles. It produced just under 65 million vehicles that year. The industry breaks even on factory output at about an 80% utilization rate, roughly where the industry was in 2006. And with demand falling globally by 3% or so in 2008, you would think that the industry would not be adding capacity, but it is. Capacity is increasing rapidly. By 2011, the global auto industry is likely to be able to produce 100 million vehicles in a year.

Why would this be happening? There are three reasons that capacity might expand in an industry despite overcapacity. The first reason is that some geographic segments are growing faster than average. India and China, in particular, are growing faster than the average world-wide demand and will add capacity to meet local needs. (See the Symptom & Implication, “Both new entrants as well as existing competitors have added capacity” on Second, some industry competitors can afford to add capacity under the pricing umbrella of other competitors. This is going on today in North America. Honda is just opening a new assembly plant in Indiana. Honda is operating under the pricing umbrella set by the UAW and its big three auto plants. Third, virtually all industries see capacity expansion through what we call the “learning curve” effect. A plant in operation can become more productive each year simply by learning to do things more efficiently. This increase in productivity causes the plant capacity and, therefore, the industry capacity to increase.

We have studied over fifty industries in overcapacity. In each of those industries where we had the opportunity to measure plant productivity, capacity increased every year due to the “learning curve” effect. This effect works even in slow-growing industries, such as newsprint. Its effect on capacity grows as the rate of growth in the industry increases. A high tech plant would have a greater growth in productivity and capacity from the “learning curve” effect than would a newsprint facility.

Industries that appear to be in severe overcapacity may still be adding capacity. This growth in capacity adds to the pressure on industry prices and margins. It prolongs the industry’s pain from overcapacity. (See the Symptom & Implication, “The company believes the industry will be more diplomatic about adding capacity” on

Monday, December 22, 2008

Killing the Goose that Laid the Golden Egg

About twenty-five years ago now, American Airlines introduced the first Frequent Flyer Program, which rewarded airline passengers miles for the “mileage” they had flown on the airline. These miles were convertible into airline tickets. This program spawned many copy cat competitors, including all the major airlines, hotels, car rental agencies, cruise lines and many other non-airline companies who wished to create a loyalty program. In many ways, the loyalty programs that the legacy airlines offered enabled them to keep their most attractive customers from falling for the blandishments of discount airlines, such as Southwest and Jet Blue. That may be coming to an end.

Up until about ten years ago, I would value an airline mile at roughly four cents, given the price of flying back then. Today, some experts in air travel estimate that the current value of an airline mile today is about 1.2 cents – that is, when you can get it. Many people seeking to cash in their awards can not use the tickets. What happened? The airlines have raised their prices on these programs and reduced the availability of the awards. (See the Symptom and Implication, “Some competitors seek price increases more aggressively than others” on They raised their prices by demanding more miles to redeem an economy seat. They also added extra charges for fuel, issuance of award tickets, and so forth. They reduced the seats available to the award programs. Since there are so many miles chasing fewer award seats, the awards are much more difficult to claim.

The airlines themselves redeem the miles at about one cent. Several airlines, including Delta and United, allow passengers to use miles to pay for tickets on their web sites. These programs value the airline miles at one cent per mile. The same web sites offer hotel stays and auto rentals at less than one cent per mile.

The airline programs are becoming uncompetitive. The current programs in the legacy airlines are less generous than those of most of the major hotel companies and cruise lines. The credit card companies, themselves, now offer cash rebate programs that redeem miles at between one and two cents each. The new Schwab Visa card, which we described in our previous blog, rebates 2% on all purchases. Customers who spend a lot of money are likely to notice these more attractive programs. (See the Perspective, “Failure Shifts More Share than Success” on

The legacy airlines are in the process of losing one major advantage they had over the discounters. Only 48% of airline program customers are satisfied with the value they get from the Frequent Flyer awards programs. The percentage who claim that the airline award programs sway the way they make ticket purchases is even lower. It is 25% today, down from 31% only two years ago. Yet, the programs major purpose is to win and hold customers who fly a lot and spend a lot. It looks from here like those programs are likely to falter.

Thursday, December 18, 2008

The New Schwab Credit Card and What it Tells Us

Charles Schwab Corporation is introducing the Schwab Bank Invest First Visa Signature credit card. This no-annual-fee card offers an unusual set of benefits. First, it returns a 2% cash rebate on all purchases, one of the highest rebate promises around, and it has no pre-set spending limits. Most other cards impose minimum spending hurdles before the rebates kick in. Next, there are no category (e.g. type of retail) restrictions on the spending with the card in order to earn the 2%. This benefit contrasts with most rebate card programs that require spending at certain locations to get the highest rebate. Finally, Schwab charges no foreign exchange fees if the card is used overseas.

You see from the name of the credit card, the “Visa Signature” brand, that the card is targeted for big spenders. It is likely to succeed in attracting them. The benefits are very attractive in today’s market.

You may recall that the rewards credit card started back with the Citibank American Advantage card. This card offered one airline mile for every dollar spent on the credit card. And the card itself carried a fee. Until a few years ago, the value of the mileage rewards on credit cards was around 2%. Today, it is more likely to be 1%, if that, and the miles can be very difficult to redeem. It is no wonder that the largest growth in reward cards is in non-airline reward cards. This new Schwab card offers benefits worth at least twice what the airline cards offer and it charges no fees to boot.

Schwab is introducing this card in order to accomplish two goals with these very attractive large customers. First, they expect that new high net worth customers will open accounts with Schwab. Second, Schwab expects that many customers will consolidate their other credit card relationships with Schwab in order to take advantage of Schwab’s generous terms. Once the customer opens an account with Schwab, and begins using the new credit card, Schwab will credit the 2% of spending to the customer’s Schwab account. The customer, in turn, will use either a check or a debit card to withdraw the reward money.

This new Schwab product illustrates two patterns of market evolution. First, industry profits are high. You will read about the credit losses that the companies are incurring. They are, indeed, rising. Still, credit card issuing is a very profitable business. In fact, profits are so high that new entrants, like Schwab, are continuing to enter the market. The market is very attractive, no matter the anguished cries, as long as it has new entrants. (See the Symptom and Implication, “New competition is entering a settled market” on Second, companies who sell several related products tend to dominate industries. Each new product may stand on its own base of profits, but it may also complement other products in the customer relationship. (See the Perspective, “Achieving the Low Cost Position” on Industry leaders can afford to subsidize new products, if they have to, if they can gain new revenues and profits, either from selling a new customer other products or the new product to current customers. As long as the customer opens a new account, or consolidates balances with Schwab, Schwab will gain more than just the credit card profits from this new credit card.

This is not an uncommon pattern. You may recall the Netscape story. Netscape introduced a very profitable browser. Microsoft, as the industry leader, felt threatened by Netscape’s browser and introduced Internet Explorer in answer to it. However, rather than selling the Internet Explorer, Microsoft included it free in its Windows package and wiped out Netscape’s market. Microsoft figured that it made more sense to have the browser customer stay in the Windows family than to let that customer loose where someone else might offer him another operating system or office tools.

The Schwab move is consistent with the way the company has approached the market since Charles Schwab’s return as CEO. Before his return, the company was stumbling. It had raised its prices well above its peers. Customers were defecting. The company was losing market share and Schwab’s returns were dropping. Schwab returned as CEO, immediately reduced prices and the company became much more aggressive in the market place. The company’s returns grew apace. Nice job by Charles Schwab and the company.

This new Schwab credit card will threaten a lot of people, especially the legacy airlines. More on that in our next blog.

Monday, December 15, 2008

Blockbuster vs. Netflix... Again

Blockbuster is under pressure, and has been for a number of years. It is closing hundreds of stores. Still, it continues to operate over 3,900 stores in the U.S. and nearly 2,000 outside the U.S. The reason for its struggles is simple: Netflix. Netflix beat Blockbuster by offering a better business model to the American consumer. Eventually, Blockbuster copied the Netflix business model. But by then, Netflix was a powerful competitor. Blockbuster has been unable to unseat Netflix from its position of movie rental leadership.

These two companies are about to square off again.

Blockbuster recently introduced a television set top box to deliver movies on-demand over the internet. Netflix also offers a similar service. We will use the Customer Buying Hierarchy (i.e. Function, Reliability, Convenience and Price) to analyze the two services and declare a winner before the battle starts. (See the Perspective, “How Customers Buy”, on

Function refers to how a customer uses the product. With internet downloading, the key Function is number of movie titles available. Blockbuster offers 2,000. Netflix offers 12,000, though many of those are older movies, independent films and T.V. shows. The Function advantage, though, clearly goes to Netflix.

Reliability refers to the way a company delivers on the promises made or implied to its customers. Such benefits as product quality, warrantees and on time delivery define Reliability. The Blockbuster service offers something called “progressive downloading” in order to ensure that the consumer receives DVD quality on the movies downloaded. Netflix offers its internet video with standard streaming quality. Streaming quality can be variable, depending on the bandwidth and the type of connection used. With fast connections, standard definition content approaches DVD quality. The advantage on Reliability goes to Blockbuster.

Convenience refers to the ease with which a customer may purchase and install the service. Blockbuster offers a proprietary set top box produced by partner firm, 2Wire. Once the proprietary set top box is on the consumer’s television set, it takes a few minutes for a downloaded movie to begin playing because of the progressive downloading feature. The Netflix service does not require the proprietary set top box. In fact, it operates with a large number of hardware items, many of which are already attached to consumer televisions. Netflix connects through both TiVo DVRs and Microsoft’s Xbox360, for example. More consumer electronics manufacturers will add the Netflix streaming feature to their set top boxes in the future because it is likely to be popular. This implies that the cost of the hardware required to play Netflix movies is either low, because the consumer already has the product, or will fall in the future as more hardware competitors pile into the market. In addition, the standard streaming feature allows the downloaded movie to play within a few seconds of the initiation of the download. The Convenience advantage rests with Netflix.

Pricing refers to the final cash payment the consumer makes to the seller of the product. Blockbuster has a two-part pricing scheme. In the first part, the company offers the set top box for $99, which includes 25 movie credits with the initial $99 purchase. In the second part of its pricing scheme, Blockbuster plans to charge $1.99 to $3.99 per movie. Netflix, on the other hand, is taking a very aggressive stance toward online downloading. It is piggybacking its online service on its existing DVD by mail service. In the cheapest version of its DVD by mail service, a consumer pays $8.99 per month. But with that payment, the Netflix consumer pays nothing extra for as many online videos as he cares to download in the month. Clearly, the Price advantage rests with Netflix.

Netflix has already proven that its fixed price per month pricing model is more attractive to consumers than is the video on-demand payment model that Blockbuster uses in its new online service and in its stores. Consumers clearly prefer the Netflix approach. So, why try the Blockbuster model again with this new online service?

In summary, Netflix wins on Function, Convenience and Price. Blockbuster wins on Reliability. In the new online service, as long as Reliability is acceptable, Netflix is the clear winner.

Thursday, December 11, 2008

Cost Standards Come to the Service Industry

For many years, managers manufacturing have measured activities to a farthing using methods developed over a hundred years ago with the time and motion theories of Frederick Taylor. But throughout most of these last hundred years, the service industries have managed to elude this management approach. That may be changing.

The major consulting firm, Accenture Ltd., has a unit named Operations Workforce Optimization (OWO). This consulting group has created labor standards for several retail chains. These labor standards create the equivalent of standard costs for service employees, such as cashiers and stock people.

These new standard cost measurements, along with ubiquitous electronic technology, enable retailers to measure precisely the productivity of some service employees. A clock on the cash register starts as soon as a cashier rings out the previous customer. The clock continues to run until the current customer has paid and received a receipt. This measure of time compares to standards established by OWO and the company. The company then counsels low-performing cashiers to improve their times. OWO maintains that its methods can cut labor costs by 5 to 15%.

The question is, how do retailers best use this cost innovation? Certainly, they should be able to reduce costs by bringing poor performing employees up to a reasonable standard. At least some of the cost savings originate here. But they also should be able to improve customer service by reducing the time the customer must spend in the check-out line. Of course, reducing a customer’s time and reducing workforce at the same time can quickly work at cross purposes. There is where management must balance conflicting opportunities. In some cases, the cashiers, who are under the measurement system, have told customers they cannot talk to them, or do anything extra, because they are “on the clock.” In other cases, customers have found that they do, in fact, spend less time checking out. It will take an astute management team to make these trade-offs properly so that costs go down and customer service goes up at the same time. If the customer sees no benefit, the cost reduction can become self defeating. (See “Costs: The Last Consideration” in the Perspectives on

These cost management innovations by OWO and its client retailers are examples of efforts companies make to reduce the units of input, in this case employees, not producing output, in this case customer transactions. The simple measurement of employee productivity is one major approach to reducing lost or wasted input. There are several other approaches producing the same effect. You can shift demand from high demand to low demand locations or times. You can improve the accuracy of the forecast in order to staff more appropriately. You may use short-term sources of help to shave the peak of demand with stretched capacity. And you can speed the process so employees spend less time waiting. (See the cost reduction ideas in the Improve/Costs/Reduce Units of Input Available but not Producing Output on

Each of these approaches improve productivity if the company implements them right. If they are done poorly, however, they can actually reduce margins.

Monday, December 8, 2008

The Good News and the Bad News of Reliability in Product Innovation

Over the years, we have studied several thousand customer buying decisions. We concluded from these studies that customers buy in a hierarchy of needs: Function, Reliability, Convenience and Price. Functions describe how a customer uses a product. Reliability defines how the company fulfills the promises made or implied to the customer. Convenience indicates the ease with which the customer can find, purchase and install the product.

Reliability is critical to a company’s success in any market, save the very fast growing, newly-developing markets. (See “Reliability: The Hard Road to Sustainable Advantage” in the Perspectives on And, even there, it quickly demonstrates its value to a company who would rely upon it. Reliability indicates to the consumer that the product works, or will be fixed quickly if it fails. For the distributor or retailer customer, Reliability of a manufacturer indicates that the product will be delivered as and when it is promised and that the company will maintain a consistent market presence with the retailer or distributor.

Reliability innovations are powerful factors for both good and bad. Two examples.

A good news story. I traveled to Philadelphia recently. The Philadelphia natives speak fondly of Wanamaker’s department stores, gone now for several years. The department stores are now part of Macys. At its beginning, though, Wanamaker’s built its success largely on Reliability.

John Wanamaker started his first store in the late 1800s. People called him “Honest John.” He attributed his success in business to his golden rule of “fair value, courtesy and satisfaction.” He spent much of his time working to gain the trust of his customers. This trust bred customer loyalty, which led to bigger sales and profits. He taught his sales people to avoid pressuring customers. They should, instead, act as guides for them around the store. This created a bond between the sales associates and customers. Some of these sales associates worked for Wanamaker for over thirty years and kept their customers coming back. The pricing practice at the time was to haggle with customers around the list price. Wanamaker did not like that. He listed one price and then promised a money-back guarantee if the customer were not satisfied. These tactics certainly paid off for Wanamaker. By 1900, he was the largest retailer in the world.

Advance Micro Devices offers a bad news example of the power of Reliability. In the fall of 2007, the company introduced the Barcelona chip product. The Barcelona chip was part of the Opteron family of chips, which offer customers higher performance and higher prices than the average chip in the marketplace. Unfortunately, Barcelona was late to the market and, worse, had early technical problems. These Reliability failures contributed to substantial losses for the company for a year. The big beneficiary of AMD’s problems has been Intel. Intel now has an 81% share of chips for PCs and servers. That share has risen more than four percentage points from 2007. AMD’s Reliability failure opened the door for Intel and Intel was able to take advantage of it.

AMD learns from its mistakes, however. It has come back strong in the past. Recently, it introduced the Shanghai chip to replace the Barcelona product. AMD did not release Shanghai until it was thoroughly tested by beta customers. Perhaps Reliability will start to work in favor of AMD this time. (See the Symptom & Implication, “Competitors are emphasizing reliability in product quality” on

Monday, December 1, 2008

Market Share at the Low End of the Market

I was struck by a recent article about statins. A recent study has found that these cholesterol lowering drugs reduce the heart risk in even healthy patients. That fact was not what struck me, though. What jumped out at me was the size of the market share for generic statins. The generics in the statin market make up 49% of total prescriptions. The well-known Lipitor is the leading branded statin, at 27%, followed by Crestor at 9%, Vytorin at 7%, and Zetia at 6%. But the generics dominate all of those branded drugs. (See “Low-end products are gaining share of market” in the Symptoms and Implications on

In our study of several hundred Price Leader products, those at the low end of a market, we found that there were two basic types of price leader competitors. Price Leader competitors distinguish themselves from the industry-leading Standard Leader products on the basis of offering different benefits to either, or both, of the buyer of the product and the user of the product. The buyer and the user may, in fact, be the same person, but their respective needs differ in each activity. (See “Turmoil Below: Confronting Low-End Competition” in the Perspectives on

The first type of Price Leader we call a Predator. Predator products offer the user the same benefits as the industry-leading Standard Leader product, but offer fewer benefits for the buyer. For example, the product may have the same ingredients but have a lesser known brand name or be more difficult to find in the stores. Private label suppliers, PC clone makers, Advanced Micro Devices, semiconductors and Drypers disposable diapers are examples of Predator competitors.

The second type of Price Leader product is a Stripper. This low-end competitor reduces benefits for both the buyer and the user. These companies reduce the Functions and Features available to the user. They offer the buyer less well-known brand names, low marketing budgets and often inconvenient locations for purchase. Jet Blue Airways, Motel 6 and Costco Wholesale Corp are examples of Stripper competitors.

It is rare for these low-end competitors to garner more than 15% of a market’s unit sales. It does happen, but not often. When it does happen, it is most likely to be a Predator competitor who will do it.

Generic statins are Predator products, but their market share is astonishing. It serves as eloquent witness to the power of institutional buyers over corporate marketing. The big buyers of statin drugs, corporations and insurance companies, have forced the growth of the generic drugs. The drug companies’ marketing programs have ceded market share to the generics in order to hold the branded product’s prices high. My guess is that the calculus behind this decision by the drug companies is a good one, though the trade-off between a high market share and lower price, compared to a higher price and much lower market share, are probably pretty close.

Monday, November 24, 2008

Masters of the Cost Cutting Universe

General Mills is a $13.7 billion food company. In 2007, the company increased its profits by 13% on a 10% increase in sales. It enjoys higher margins than either Kraft or ConAgra.

The company reaches these margin heights by a constant and unrelenting focus on improving the efficiency of its operations. The attention to cost containment emanates from the very top of the company.

Here are some of the cost savings the company has implemented in the recent past:

* Get rid of some of the fourteen different pretzel shapes in its Hot’n Spicy Chex Mix.

* Eliminating half of the more than fifty versions of its Hamburger Helper product.

* Eliminate unimportant spice and cheese pouches in the Hamburger Helper product.

* Shrink the size of the product box, while keeping the product serving size the same in order to reduce shipping costs.

* Eliminating multi-colored lids on Yoplait yogurt.

We have studied patterns of cost reduction for a number of years. Costs are Inputs of people, purchases or capital. These Inputs produce product Outputs. The cost reduction objective is to reduce the ratio of Inputs to Outputs. We have observed that there are four separate approaches to reducing costs:

* Reduce the rates the company pays for the use of an Input

* Reduce the number of units of Input that are wasted or idle in the production of the Output

* Redesign the product or the process to avoid activities or steps that are currently undertaken in the production of the Output

* Find new customers and sales volume, i.e. more Output, for fixed cost Inputs

The examples of the real-world cost reductions at General Mills all fall under the third category redesign the product and the process in order to reduce activities. In this case, the company eliminated components of the product that brought little value to the customer. The components the company eliminated may have generated some revenues, but the revenues they generated were far lower than the costs they caused the company to incur. (See the Perspective, “Cutting the Right Cost”, on

The Improve/Cost section of StrategyStreet contains several hundred brainstorming ideas to control costs in even the best of markets.

Tuesday, November 18, 2008

Nike Builds Brand Loyalty

Nike, ever the innovator, has found a new way to build brand loyalty. It has created a web site,, that connects runners around the world. This web site tracks a runner’s data and allows a runner to join with other runners all over the world to improve their times.

To make this online group work easily, the company developed a $29 Sport Kit sensor that, when synched with an iPod or Nano, calculates the runner’s speed, mileage and calories burned and provides a method to upload that data to The company has sold over a million NikePlus iPod Sport Kits. Runners have used the web site to create groups where members challenge each other to improve their times and distances. Does this work? Well, in 2006, Nike accounted for 48% of all running shoe sales in the U.S. By 2008, its share was up to 61%. At least some of that must be due to the social networking site.

Over the last few years, we have studied several thousand product innovations. We have found that product innovations fall into three major categories: First, you can provide information to your customer; second, you can reduce the resources your customer uses with the product; and, third, you can improve your customer’s experience with the product.

Recently, we developed an article which outlines eleven questions, based on these three categories, that you can use to develop your product innovations. (See “Patterns of Product and Service Innovation” in the Perspectives on Nike’s innovation falls under the “improve the customer’s experience” category. Nike has provided a good answer to one of the eleven questions: Can you add to your customer’s sense of pride and well being?

Congratulations, Nike, on another customer insight.

Thursday, November 13, 2008

The Two Best Consultants in the World Warn the Associated Press

The Associated Press is a cooperative. This “non-profit” is owned by 1,500 newspapers. It employs its 3,000 journalists in 97 countries to provide news stories to these newspapers, as well as others in the media, including radio and T.V. stations and web sites. This company has been getting some significant warnings lately about its cost structure.

Many of its customers are struggling in the new media world. Newspapers and radio stations, especially, are suffering from the onslaught of web-based advertising. The first warning has come from its customers, one of the two best consultants. (See “The Two Best Consultants in the World” in Perspectives on More than 100 newspapers have announced plans to cancel their Associated Press subscriptions. By defecting, these 100 customers have told the Associated Press that its value proposition is out of line. The company is asking too high a price for its performance. In response, the company has cut some of its rates.

It has gotten equally ominous warnings from the second of the two best consultants in the world, competition. New competitors are entering underneath its current price umbrella. These new competitors offer competing services at lower prices. (See “New entrants are penetrating the distribution channels of the industry’s leading competitors” in Symptoms and Implications on CNN has announced that it is starting a wire news service. PA SportsTicker offers stock tables and sports scores at very low prices. GlobalPost is creating a network of international news correspondents with a planned launch in 2009. Several of Ohio’s largest newspapers have formed an organization to pool in-state reporting. All of these entities must have a low cost structure in order to survive under the discounts they must to offer in the marketplace to pull customers away from the Associated Press. (See “Substitute products have grown in importance” in Symptoms and Implications on

The Associated Press has to listen to both of these sources of warning. They are telling the company that the cost structure and prices it enjoys today is not sustainable in the current competitive world. The company must examine its cost structure soon to ensure that it is able to create economies of scale to use against these low-end new entrants. Then it needs to re-segment its market to be sure that the benefits it offers each segment are more than worth the price it charges the segment. Finally, it needs to restructure its pricing system so that each customer segment gets good value; that is, performance for price.

Monday, November 10, 2008

Nearing End Game for the Domestic Auto Industry

Consumer Reports recently had a load of bad news for the domestic auto manufacturers. The big car retailers had even worse news.

Consumer Reports issued a report showing that the three domestic automobile manufacturers, GM, Ford and Chrysler, trailed Asian manufacturers in quality. The Chrysler cars were rated very low on the quality scale. The GM cars were hit and miss: some of good quality, others of poor quality. Ford generally rates as the best of the domestic automobile manufacturers in automobile quality. The knock on Ford from Consumer Reports is that its car styling was boring.

We have observed, through thousands of customer interviews that all customers purchase using a hierarchy of criteria: Function, Reliability, Convenience and Price, in that order. (See “How Customers Buy” in the Perspectives section of StrategyStreet.) Automobile styling is a form of Function. Automobile quality is a measure of Reliability. In all Hostile markets, those industries with overcapacity, the winners in the industry succeed on the basis of high Reliability. Function and Price usually mean little because competitors copy any successful Function or Price innovation very quickly. Convenience is important. However, a company that loses its Reliability will also lose its Convenience, even if it is the leader in the industry.

The domestic auto manufacturers have lost their reputation for high Reliability. Now they are losing their Convenience, as the big car retailers write off the value of their domestic branded stores. Recently, the third and the fourth largest automobile retail chains, Sonic and Group 1, wrote off the major portion of their remaining investment in GM, Ford and Chrysler stores. In each case, the dealerships of the big three automakers accounted for less than 20% of the sales in the group. These big retailers are Very Large wholesale customers, those who determine the future of the industry and the Convenience with which retail customers may purchase automobiles. Many of the domestic brand of stores will close, particularly in these large dealership groups. Very few new outlets will open. As a result, the Convenience advantages previously enjoyed by the domestic automobile manufacturers slowly ebb away. That leaves them with little left to stand on. Neither Function nor Price will save them. Convenience has been their major strong point, but they are losing that as their Reliability slips.

You might ask why Reliability has slipped. The companies made choices that reduced the quality of their automobiles. This is an example of a self-defeating cost reduction, which sinks many competitors in Hostile marketplaces. (See “Success Under Fire: Policies to Prosper in Hostile Times” in

Thursday, November 6, 2008

A Win Win Cost Reduction/Performance Innovation in the Cell Phone Industry

The cell phone carriers are about to introduce a product innovation, called a femtocell, to improve cell phone reception within a home. These femtocells are about the size of a toaster. The wireless carriers will install these mini cell phone towers. The tiny tower will connect with cell phones inside the consumer’s home through a broadband internet connection to the telephone network. The wireless carriers hope that this innovation will increase the reliability of the wireless system to the extent that the consumer will be able to get rid of the $50 a month average land line cost. The consumer will pay about $100 for the femtocell, plus ongoing monthly service fees for the “enhanced” telephone service. (See the Symptom & Implication, “Companies are trying to create upscale niches” on This sounds like a pretty good deal for the consumer, assuming they can get rid of their land lines. The innovation should substantially reduce the customer’s telecommunications costs. (See the Perspective, “The Choice of New Products” on

It is an even better deal for the wireless carriers. These carriers pay about $200 for each of these boxes. They will recoup that $200 through the $100 installation fee plus the ongoing “enhanced” service fees. The beauty of the technology is that it lets the wireless carriers shift some of the cost of an increase in wireless capacity to their consumer customers. The capacity addition helps the carriers avoid some of the costs of adding new and expensive transmission towers.

We have studied patterns of cost reduction for a number of years. Costs are Inputs of people, purchases or capital. These Inputs produce product Outputs. The cost reduction objective is to reduce the ratio of Inputs to Outputs. We have observed that there are four separate approaches to reducing costs:

- Reduce the rates the company pays for the use of an Input

- Reduce the number of units of Input that are wasted or idle in the production of the Output

- Redesign the product or the process to avoid activities or steps that are currently undertaken in the production of the Output

- Find new customers and sales volume, i.e. more Output, for fixed cost Inputs.

This femtocell innovation is an example of the third cost management technique: the redesign of a process to reduce activities. This particular redesign reduces the capital requirements in the industry by shifting activities and investments to the consumer for no compensation. In fact, in this case, the consumer pays for the shift directly.

This certainly looks like an attractive win win deal.

The Improve/Cost section of contains several hundred brainstorming ideas to control costs in even the best of markets.

Monday, November 3, 2008

Standard Leader Expands in Tough Market and Uses Price

Kohl’s Corporation is opening forty-six stores soon as part of a plan to gain market share as the busy holiday season starts in the U.S. Today, Kohl’s has something less than 1,000 stores open in the U.S. The company expects sales at stores open for a year or more to be down 2 to 4% during this year’s holiday season compared to last, so they are opening stores to make up for some of the sales fall-off.

But that’s not all they are doing. The company is a middle market chain competing with the likes of Penney’s and Macys. The company plans to renovate sixty existing locations in 2009, twice the number it will renovate in 2008. Probably boldest of all is their plan to use low prices to gain share.

The company expects to advertise its lower prices in its holiday marketing early in the season to be sure that customers know their spending goes further at Kohl’s. This price thrust will work only if Penney’s and Macys do not follow Kohl’s lead. (See the Symptom & Implication, “Large competitors are maintaining price levels as smaller competitors discount”, on If they don’t, they are in a Leader’s Trap. A Leader’s Trap occurs when an established industry competitor maintains a price umbrella and cedes share to a discounting competitor in the mistaken belief that customers will stay loyal to the established competitor by paying a premium for its product. Over time, the company in the Leader's Trap not only loses share, but also sees prices fall to a level near the price established by the discounting competitor. (See the Perspective, “The Leader’s Trap”, on

Kohl’s is almost certain to gain market share at the expense of weaker competitors, such as Mervyn’s and some of the regional department store chains, who do not have the financial where-with-all to stay with them. But this market share is available to Penney’s and Macys, as well. If these latter two Standard Leaders don’t follow, they will be making a mistake.

Thursday, October 30, 2008

Evolution of Markets: Patterns in Steel, Autos and Airframe Industries

The steel, automobile and airframe manufacturing industries illustrate three different stages of the evolution of mature markets. The theme is that mature markets with strong unions eventually end up with the workforce as the only true stakeholder in the business. Everyone else is secondary, and as a result, the workforce is at real risk of permanent job losses over a period of time.

The story of Bethlehem Steel illustrates the end game in this evolution. Through most of the 80s and 90s, Bethlehem lobbied Washington to protect its business against the import of foreign steel, which it argued was subsidized and dumped in the U.S. All along, though, non-unionized companies like Nucor were gaining share rapidly in the domestic market. Bethlehem’s costs were much higher than the industry as a whole. The company suffered from very high wages compared to both foreign mills and non-union domestic mills, and from work rules that reduced the productivity of the workforce. Because the company had no profits, it could not invest in its infrastructure. This low investment yielded older and less efficient mills, compounding the company’s cost problems. As the company faltered, pension and benefit payments to retirees soared, while the active workforce shrank. The unions refused to negotiate away some of these uncompetitive cost drivers. Customers did not have to put up with inefficient costs and the slow reaction to price discounting that Bethlehem imposed upon them. They left for greener pastures. The company filed for bankruptcy in 2003. A financial investor bought the company’s assets, and negotiated new deals with unions who, chastened, gave him a sweeter deal than they gave to the company’s previous management. The retirees lost all or most of their pensions. The steel works have fewer, and lower paid employees.

Ford, and the rest of the domestic automobile industry, is just a few years behind in this same evolution. Recently, Kirk Kerkorian began selling off his investment in Ford. Kerkorian has proven himself to be a very savvy investor over these last thirty years. He sees little future for Ford. Why? Because neither customers nor investors have any true stake in the company. The company is essentially controlled by the United Autoworkers. The autoworkers stand by their demands and inefficient costs despite the fact that the domestic industry is hemorrhaging losses and reducing employee numbers at an unprecedented rate.

What is likely to change this situation? Not really anything. Yes, the government is likely to inject cash into the industry, but this will simply delay the inevitable. Costs are too high, investment and product quality are too low, customers are leaving and retiree costs are becoming a higher proportion of industry unit costs. Haven’t we seen this story before? See above.

Now we come to the airframe manufacturing industry. Boeing is the leader here. The Machinists Union at Boeing is now on strike, largely over the issue of job security. These machinists are well paid by U.S. standards. The average machinist earned an average of $65,000 a year last year, including overtime. The company’s critical issue in this strike is whether the company can turn over more of its work to outside contractors. The union argues that they have already lost too much work because of Boeing’s outsourcing to contractors.

Now, think of the union as a supplier for a moment, offering a service for a price. The union, as the leader, is losing share to emerging contractor-based workers. (See the Symptom and Implication, “New entrants are penetrating the distribution channels of the industry’s leading competitors” on The union stance here is that they do not like losing market share at Boeing to other companies who can offer the same, or better, product at a lower price. Sounds like steel and autos, doesn’t it?

Now let’s ask another question. Do you suppose that the machinists would be willing to pay a higher price for a product just because it was manufactured by union employees in the United States? Overwhelmingly, it appears that most would not. It would be interesting to know how many union employees purchased domestic made color televisions during the 70s and 80s just because they were manufactured domestically. Today, all televisions are manufactured in Asia. Union employees are just like the rest of us when it comes to being their own money. They do not want to pay more for the same product than other people have to pay. Now, back to the Boeing situation.

Boeing’s management has held tight to its position that it must be able to outsource more of its current product manufacturing. They have done this in the face of some cancelled orders and a stock price that has fallen well over 60% from its peak in 2007. Boeing’s strong financial position, high market share, and relative lack of current competition strengthens the union’s position. However, those same economics one time held for both Bethlehem and Ford somehow competition found them anyway.

There is now a tentative agreement on the table. Boeing agreed to raise wages by a total of 15% over the four years of the contract and to pay bonuses totaling $8,000 to each worker during the first three years of the contract. The union has agreed to allow Boeing to expand the use of contractors to deliver components directly to assembly lines, but no further. The strike has lasted for 52 days, costing the company about $100 million per day in lost revenue and delays. So, let’s consider the likely fall-out from this settlement.

The union got a very generous settlement that promises to hurt them in the long-term. The wage increases in the face of a stronger dollar and weakening world-wide economies will surely make the Machinists Union employees even less competitive on the world market than they were before the strike. They get money now, but far less job security in the long-term.

The company, for its part, has agreed to pay a higher price for its Machinists Union labor. It won at least part of its battle over the issue of contracting. You can bet that contracting will grow in the future, at the expense of union positions. In addition, the Machinists Union, as a supplier of a labor service in this instance, proved itself to be highly unreliable. The daily cost of the disruption is the equivalent of about three years worth of wages for each employee in the Boeing group of the Machinists Union. That is a stiff price for Boeing to pay, and will certainly play into their consideration of where to place any new manufacturing facilities in the future. Again, this will work against the creation of new Machinist Union jobs in the future.

Unions in mature industries will eventually have to think of themselves as suppliers offering a service for a price. (See the Symptom and Implication, “The industry leaders are losing share” on The steel and automobile industries join many other industries, including semiconductors, textiles and paper in suggesting that there is little likelihood that a high-priced supplier can sustain its position, even if the supplier is the workforce.

Monday, October 27, 2008

A Standard Leader Blocks the Price Leader Competitor

Enterprise Rent-A-Car is an astute, well managed company. They have grown to the number one position in automobile rental by using their management skills to beat the likes of Hertz, Avis and National. Now they are starting to close the door on a growing low-end, Price Leader, set of competitors. A Price Leader is a competitor or product that offers below industry-standard performance for a very low price. More than 50% of a Price Leader competitor's total unit volume is usually sold at price points below the Standard Leader product.

This low-end, Price Leader, part of the business is car sharing. This is a club-like service where members join and then rent cars by the hour in locations close to their home or business. The leader in this industry is Zip Car Inc. This company has 250,000 members and 8500 corporate clients. Zip Car, as well as most of the industry, exists only in the larger cities in the United States.

So what has Enterprise done to stunt the growth of Zip Car? It has gone after the largest customers in the industry, in big geographic markets, with a comparable product. (See the Symptom & Implication, “Low end products are gaining share of the market” on Enterprise has created WeCar branches at several partner businesses around the country. It plans to deal only with the largest customers, businesses. By contrast, Zip Car gets most of its business from consumers, a costlier market segment to serve. It currently has WeCar locations at Google’s office in San Francisco, Washington University in downtown St. Louis and at sporting goods retailer, REI’s offices in Kent, Washington. The company has been attracted to this car sharing price point because it is a booming business in an otherwise slow-growth industry.

In the long term, it is likely that the industry’s Standard Leaders, including Enterprise and Hertz, will be the leaders in this low-end price point. (See the Perspective, “When Product Mix Matters”, on

Monday, October 13, 2008

Avoiding Wastage of Resources

Honda has the most flexible auto plants in the U.S. It does so with simple modifications to the robots and assembly lines used to assemble its products. Of course, this high degree of flexibility is the result of significant investment over many years. Part of this investment included the company’s efforts to ensure that vehicles are designed to be assembled in the same way, even if the parts of the vehicle differ. This flexibility has become a key strategy advantage for the company as the auto market gyrates due to volatile gas prices. Honda has the capability of adjusting its production faster than any of its competitors.

Creating factory flexibility is one way that a company reduces the units of Input it requires to produce a unit of Output. In Honda’s case, the units of Input it was able to reduce with flexibility included employees and capital required to produce an automobile.

This flexible factory has enabled Honda to reduce downtime for employees and the plant assets. Downtime merely wastes the resources available for production. The auto industry has been reducing costs aggressively for many years. Honda is one of the companies who have done this well. (See the Symptom and Implication, “The industry is reducing costs aggressively” on

Here are some examples of ways other companies have reduced their unplanned downtime:

  • Allow work in process to follow multiple paths to completion to avoid delays at any waypoint

  • Break bundled supplies into their component parts where components of a bundle are used at different rates

  • Enable an employee, or a component, to serve multiple functions

  • Ensure that all required components are available at each step in the process

  • Duplicate critical components to avoid any potential shutdown of the process due to the failure of a single component

  • Have ready answers for issues that can slow or stop a process

  • Offer a service package to customers to avoid the failure of the product at the customer location. This service may also bring a price premium.

  • Build installation instructions into a component

There are many hundreds of ideas to help a company reduce its unit costs and improve its overall productivity, measured as units of Input divided by units of Output, on (see the Improve/Costs section of StrategyStreet). But any cost reduction program should focus on the right costs. (See the Perspective, “Cutting the Right Cost” on

Thursday, October 9, 2008

Price Leaders Against Standard Leaders in Troubled Times

For once, the airline industry Standard Leaders, the legacy airlines seem to be improving their positions compared to the Price Leaders, the discount airlines. In our system of analysis, a Standard Leader is a competitor, or one of several competitors, or products that set the standard for performance and price in an industry. A Price Leader is a competitor, or product, that offers below industry-standard performance for a very low price. So far, none of the legacy airlines has gone back into bankruptcy. On the other hand, a number of Price Leader discount airlines have failed, including Frontier Airlines and Skybus Airlines. What has happened? Three things.

First, the bankruptcies of the legacy carriers helped those companies drastically reduce their high costs. Some analysts have noted that the difference in operating margins of the Price Leader discounters and the Standard Leader legacy carriers is only 2% today, down from 7% five years ago. A 5% cost advantage is not much in the way of a Price Leader’s low cost structure, which it needs in order to offer its lower prices and attract its customer segment.

In order to succeed over a long period of time, discounters always must offer a significant discount on a product that is “acceptable” in the market, if not as good as the Standard Leader product. In order to offer the substantial discounts, Price Leader competitors must have a lower cost structure. In turn, this lower cost structure is largely the result of the discounter offering fewer benefits than the Standard Leader product. We have done extensive analyses on these Price Leader companies. Our research suggests there are two separate types of Price Leaders who follow somewhat different business models (see the Perspective, “Turmoil Below: Confronting Low-End Competition” in

Second, the legacy carriers have begun selectively competing with the discount carriers on price. In many markets, the legacy carriers offer prices that are within reach of those of the discount airlines. (See the Symptoms and Implications, “As large competitors match low prices other competitors face difficulties” in In most markets, a successful Price Leader needs to offer a discount of 25% or more on its product in order to grow significantly at the expense of a Standard Leader.

Third, the discount airlines’ natural market is shrinking during these troubled times. In fact, the airline industry in general is shrinking, as measured by revenue passenger miles flown. However, the discount airlines carry a higher proportion of price-sensitive leisure travelers. This market segment is off a good deal more than is the business traveler segment, which makes up a higher proportion of the legacy airlines’ customers.

Even though today’s airline industry is seeing the discounter product become more like the legacy airlines’ product, and vice versa, these discounters still need to offer a notably lower price than do the legacy carriers. That seems to be more difficult these days.

Tuesday, October 7, 2008

Nokia in a Leader's Trap

Recently, Nokia announced that its market share was likely to fall off somewhat in the future because it was refusing to enter into a price war with others in its industry who are discounting. Nokia has decided to stand apart from the discounters in the marketplace. (See the Symptom & Implication, “Large competitors are maintaining price levels as smaller competitors discount” on Unfortunately for Nokia, these discounters include the #2 cell phone maker, Samsung, and the #4, LG Electronics. (See the Symptom & Implication, “Price wars are spreading in the industry” on The outlook on this decision is grim.

We have seen this same situation many times before. We call it the Leader’s Trap. (See the Perspective, “The Leader’s Trap” on In a Leader’s Trap, an established industry competitor maintains a price umbrella and cedes share to a discounting competitor in the mistaken belief that customers will stay loyal to the established competitor by paying a premium for his product. Over time, the company in the Leader’s Trap not only loses share, but also sees prices fall to a level near the prices established by the discounting competitor.

Nokia has announced its intention to take market share only when the company believes that the share will be sustainably profitable in the long-term. This sounds good, but won’t work. The market share the company surrenders today generates cash and, probably, profits. The major players who are discounting their prices today are, therefore, becoming stronger with the addition of more revenues and cash flows in a difficult market. On the other hand, Nokia can only become weaker. It loses cash flows. It broadcasts to all customers in the marketplace that its prices are high. How does Nokia win in this situation?

The answer: it does not. Nokia is unlikely to succeed where previous leaders, such as GM, IBM, AT&T, and many others, have failed. The Leader’s Trap always weakens the company holding the price umbrella and strengthens all the competitors underneath the umbrella. Nokia is sure to regret this tactic.

Tuesday, September 30, 2008

The Future of Starbucks

In 1903, Horatio Nelson Jackson did something remarkable. He made the first automobile trip across the United States, from San Francisco to New York City. His trip took 64 days. This time includes the waits for parts after the car had broken down. There were few roads in those days. Automobile travel was challenging in the extreme. Jackson drove a Winton Tourer automobile that he had named the “Vermont” after his home state.

Not many of us today know of the Winton and its producer, the Winton Motor Carriage Company. Winton was one of the first American companies to sell motor cars. It incorporated in 1897. By 1900, the company was the largest manufacturer of gas-powered automobiles in America. In its day, the “Vermont” was state-of-the-art.

The company continued successfully through the 1910s, focusing its marketing on upscale consumers. However, during that period, dozens of new automobile companies started up, creating intense competition. New competition led to falling sales for Winton in the early 1920s. The Winton Motor Carriage Company stopped automobile production in 1924.

Winton’s experience has something to say to Starbucks. Starbucks is the dominant leader in today’s coffee cafĂ© segment. They have shown the world how to make a lot of money on a product that had heretofore been a commodity. For years the company grew its revenues and profits by opening new stores and by raising prices with impunity. Those days are now at an end. Its fancy coffees can cost $3 to $5 each, and now it has real competition.

After dithering for a number of years, major fast-food companies, such as McDonald’s, Burger King and Dunkin’ Donuts, attacked the premium coffee market with a vengeance. (See the Symptom & Implication, “Competitors in formerly undeveloped markets have begun meeting one another” on This attack was easy. Starbuck’s prices were so high that each new competitor had margin enough to provide an excellent drink at much lower prices than Starbucks.

This competition is now serious business. The new competitors have pushed Starbucks into the Performance Leader category, at the high end of its own industry. The new competitors have become the Standard Leaders in the industry. (See the Symptom & Implication, “While still growing, some competitors are losing share” on Even worse, the new Standard Leaders are comparable, or better, to Starbucks in quality. Recently, Consumer Reports hired tasters to sample medium cups of black coffee from several competitors, including McDonald’s, Burger King, Dunkin’ Donuts and Starbucks. McDonald’s, not Starbucks, won that test.

The Winton Motor Carriage Company, too, was pushed into the Performance Leader end of its industry as companies such as Ford, Oldsmobile and others produced good quality cars for far less money. It lost out on economies of scale. Winton could not command enough of a price premium against its larger competitors to make a good profit.

Any high-end, Performance Leader, competitor should look at Price Points below them for competition. This lower-end competition may not offer the same quality but its much lower price for “acceptable” quality will skim off a significant part of the Performance Leader’s business. The lower-end competition will force more restrained pricing and real attention to unit costs on the Performance Leader.

Starbucks is not going the way of the Winton Motor Carriage Company. It will survive, and even thrive, because it has established itself as a quality brand name. But in order to thrive, it will have to be a very different company in the future. Its growth will be moderate, at best. In the future, its new stores will meet much tougher criteria for segments that have the need for, and are willing to pay for high-end coffee drinks. Its pricing is virtually certain to decline to close some of the gap with the new Standard Leader competitors. It will evolve into a company who understands its unit costs far better than it does today. (See the Symptom & Implication, “Competition is beginning to focus resources on market segments as market growth slows” on

Tuesday, September 23, 2008

Commodity Pricing

In 2002, the average price for nickel was around $3 a pound. Shortly thereafter, the market took off. The price for nickel reached a peak of over $23 a pound in 2007, and has since fallen off. Today, its price is something short of $10 a pound. Still, the $10 a pound today is far above the $3 a pound of six years ago.

Despite prices that look very high in the light of history, nickel production facilities are closing in several parts of the world. What explains a market that could sustain a production facility at $3 a pound but cannot sustain that same facility at $10 a pound?

The answer lies in the way prices work. The price of any product is the cash cost of the next unit of production. This is true in any market but is most easy to observe in a commodity market. In a falling price environment, the cash cost of the next unit of production is approximated by the cash cost of the last production that closed. In a rising price market, the commodity price is the cash cost of the next unit brought into production. Now let’s see how this rule works.

After 2002, as demand for and the price of nickel began to accelerate, new production came on line. Some of these new mines can produce cash at prices as low as $5 in today’s market. The high prices discouraged some demand. Customers, where possible, turned to substitute products, which dampened the growth in demand somewhat. The result is that there may be as much as 90,000 metric tons of excess capacity in the marketplace, about 5% of current demand. Hence, the drastic fall of prices since 2007.

But, even at today’s $10 a pound, nickel operations are closing, which tells us that the cash costs of those operations must be above $10. How could that be when they could produce cash in 2002 with a $3 price?

The culprit here is costs. The mining industry is energy-intensive in a market where energy prices have soared dramatically. The industry uses a great deal of steel and sulfur in its production. The rising costs of these commodities have increased the cash costs of nickel production. Very few operations could continue operating at 2002’s price of $3. Most throw off cash at a price of $10 or more per pound. If the commodity costs of sulfur, steel and energy decline, so too will the price of nickel.

In summary, over the last six years, demand increased and prices rose to meet that demand. This caused customers to reduce their demands somewhat and competitors to bring on new capacity, some with relatively low cash operating costs compared to older operations. At the same time, the cash costs of operating a production facility increased dramatically because of the rising costs of other commodities used in the production of nickel. (See the Perspectives, “Must the Cycle Start Again?” and “Who Has Pricing Power?” on The net result is a 2008 nickel industry that is more efficient than that of 2002 but with higher costs of the commodities required for production. So 2002’s $3 per pound price has risen to $10 per pound. However, if the prices of the commodities the industry uses were to fall to 2002’s levels, the price of nickel would likely fall below $3 per pound.

Monday, September 15, 2008

Pricing in a Profitable Market

Over the last two years, eBay has raised its prices to improve its financial performance. Not that its financial performance has been bad. In fact, it has been good. But management believes it can be better with a price rise. The price increases eBay has provided the market have impaired eBay’s long-term future, even while improving its short-term profits.

When a leader raises prices in a marketplace, it has to consider whether it is setting a price umbrella over its competitors. This umbrella provides the competitors with enough margin to improve their products and offer tougher competition to the industry leader. Sometimes, these higher prices will also make customers mad. EBay seems to have both set an umbrella and made its customers mad.

The company is now losing market share to other competitors, especially Amazon. These other competitors have improved their offerings in the market place to make them, for some customer segments, more attractive than eBay’s product.

What alternative might eBay have had to a price increase in order to improve its margins? Perhaps the best alternative for eBay would have been to develop its economies of scale. Economies of scale don’t develop on their own. They have to be managed by the largest competitors in an industry. However, with an aggressive stance on economies of scale and with limits on price increases, eBay would put significant pressure on its competition. The competitors would not be able to compete as effectively because of the lower margins in the industry.

(For more insight, see the Perspectives, “Building on Customer Volatility”, “Failure Shifts More Share than Success” and “How Price Kills Profits” on

Monday, September 8, 2008

A Price Leader Enters the Performance Leader Market

Hyundai has announced that it will offer a luxury sedan in the U.S. market this Fall. The new model, the Genesis, purports to offer Lexus and BMW quality for a price 35% less than those competitors.

This is quite a leap for Hyundai. Its reputation in the domestic market is that of a Price Leader competitor selling primarily smaller cars. Its larger, Standard Leader, products, such as the Sonata, sell slowly in the U.S. (See the Perspective, “Why do Leaders Lead?” on for more insight.)

The company is making a classic low-end competitor attack on this Performance Leader market. It does not claim to be as good as its competition, such as the BMW. It claims only that it is good enough to be compared to BMW and Lexus. In return, it offers a substantial discount. The company hopes to attract what it calls “non-conformist” consumers who appreciate luxury but are not concerned about the brand of luxury car they drive.

The Genesis offers all the bells and whistles of the luxury sedan category. The company is putting its warranty money where its quality mouth is. Its warranty, at five years or 60,000 miles, is far better than the four years or 50,000 miles more typical of the luxury market.

Hyundai expects that the new automobile will increase its market share and boost its brand image. If the new car is as good as its early reviews, it is likely to do both.

Thursday, September 4, 2008

Union Negotiations During Good Times

Boeing and its key union, the International Association of Machinists and Aerospace Workers, are clashing over negotiations for a new contract. The company is enjoying some of the best of times. As a result, the union has unprecedented leverage. So, what do these negotiations tell us?

The odds seem stacked on the union side. Boeing is in one of its most prosperous periods. Customers are lined up to buy almost 900 planes, and its current order book is being delayed because outside suppliers have been overwhelmed by the amount of work Boeing has sent them. This is partially the result of the struggles of the outside suppliers and partially the result of growth in the business. Boeing has hired nearly 12,000 employees over the last several years to bring the union’s ranks to nearly 27,000 workers. Boeing believes it cannot take a strike because it would anger customers who are already upset with delays. The union has unusual leverage to make strong demands. Almost a year ago, the union began urging its members to set aside money in case of a strike.

Boeing has learned from the troubles of many other U.S. manufacturers. The company has three objectives in its negotiations. First, it wants to limit its pension and healthcare liability by limiting the employees covered by the plans and by asking employees to pay part of the costs of health insurance. Second, the company wants to limit future retiree benefits. And third, the company wants changes in job security language that would permit the company to farm out work or bring in outside non-union employees to save costs.

One thing is clear from the outset. The union employees’ long term outlook for job security is already poor. Boeing is paying today more than it would need to pay in order to attract qualified employees The union has set a price for its product that is higher than the current open market price. Sooner or later, the market corrects these unbalances. Often, the correction takes the form of a new, lower-cost competitor. For examples other than domestic autos, see color TVs, airlines, trucking, railroads, steel and machine tools, among others.

The two sides spin these negotiations differently. The union argues that Boeing is negotiating like it’s in bankruptcy. The company says that it wants to stay off a course that would make it look like the three domestic automobile manufacturers in a few years.

The company is right here. (See “What Makes Returns High?” on If they do not negotiate in a tough-minded way, they are almost certain to end up looking like the “Big Three” automakers in the long run. It is in the interest of all stakeholders, and especially of the current unionized workforce at Boeing, that the company hold down the rate of increase of cost for a work force that already exceeds what the company could purchase on the open market today.

This is the best, rather than the worst, time for Boeing to take a strike. Its profits are high and its products are the most popular in the marketplace. A few more weeks of delays are a small price to pay for long term safety of an employment contract that will enable the company to continue growing years into the future. The people who really cannot take a strike are those who let opportunities to hold down excessive employee cost increases slip away from them. Ask Ford, GM and Chrysler whether they could take a strike today.

Tuesday, September 2, 2008

GM Goes for Help with its Used Cars

Recently General Motors decided to provide a bumper-to-bumper full warranty for one year or 12,000 miles on its used vehicles going back to the 2003 model year. The warranty applies to GM Certified Vehicles. You might ask yourself, why would GM bother to add a warranty to cars that they have already sold? The answer is that the company wants to improve the residual values that the market puts on its used cars, and for very good reason.

The original purchaser of a car rarely holds it to the end of its life. Rather, the majority seem to sell their cars, or trade them, after about five years. The residual value of the car after five years is the value that the original owner uses to reduce the purchase price of his or her next new car. Here is where GM, and Ford and Chrysler for that matter, has a severe problem.

The residual values for foreign auto marques, especially Toyota and Honda, are far higher as a percentage of the original purchase price than are the domestic makes’ residual values. These differences in residual values are an undeniable criticism of the GM products. Any purchaser of a new car who does his homework will factor this higher residual value into his evaluation of the “cost of ownership.” The foreign makes’ higher residual values are equivalent to a deferred discount on the next car he purchases.

Here’s how this works. Assume that both GM and Toyota are selling today an automobile with a $30,000 price tag. Further assume that after five years the Toyota is worth 50% of its original purchase price while the GM make is worth 35%. These are reasonable estimates for the current market. At the end of five years the Toyota automobile is worth $15,000, while the General Motors automobile is worth $10,500. The difference of $3,000 gives the owner of the Toyota automobile $4,500 more to purchase his next car than the General Motors purchaser has. Over the course of five years, the Toyota owner spends $4,500 in total, or $900 per year, less to drive his car. That’s a savings of 6 cents per mile on a car driven 15,000 miles per year.

General Motors is hoping that its warranty on its used cars will increase their residual values by enough to offset the advantages that the foreign makes have. GM is creating a Reliability innovation that puts the company’s promise in writing that the used car will operate for 12,000 miles or one year with no problems. (See the Perspective, “Reliability: The Hard Road to Sustainable Advantage” in Will that be enough to offset the significant differences in residual values at the end of five years? Probably not, but it is a start in the right direction.

Thursday, August 28, 2008

Reliability Measures: The Good News and The Bad News

The domestic auto industry has several companies that monitor the quality of automobiles. Some are short-term in nature. The J.D. Power & Associates’ Initial Quality Survey measures the quality of buyer experience over the first ninety days of ownership. Since all automobiles are under warranty during that period, this survey measures the hassle factor associated with early problems.

Much more important is J.D. Power & Associates’ annual Vehicle Dependability Study. This report is the result of analyses of customer perceptions over the first three years of ownership of a vehicle. It better reflects customer experiences with a product. This study recently named Lexus as the number one brand among the thirty-seven brands sold in the U.S.

Durability is a form of Reliability, in our terminology. In a Hostile market, the Reliability segment of customers is usually the largest and most loyal (see “Reliability: The Hard Road to Sustainable Advantage” on This seems to be true, as well, in the automobile market. J.D. Power notes that durability is the top factor when buyers consider the purchase of their next vehicle. Durability is more important than fuel economy or design of the product.

So, who got the good news on this latest ranking? It comes as no surprise that Toyota distanced itself from its competitors. The company received the highest marks in eleven of the twenty individual award categories. The three U.S. automakers had a total of three individual awards, while Honda, Hyundai and Mazda also had one each.

If the history of other industries has anything to tell us, this Reliability recognition for Toyota guarantees that it will continue gaining market share in the foreseeable future. Given their current size, the U.S. automakers have a cloudier future. They are likely to continue losing share, especially to the Japanese manufacturers.

Monday, August 25, 2008

Schlitz, Lessons From the Past

“Schlitz, the beer that made Milwaukee famous.” The older baby-boomers among us may remember that advertising slogan. It was all over the media in the 50s and the 60s. Schlitz, after leading the domestic beer industry for most of the first half of the 20th century, disappeared. It has been gone now for a long time. Recently, though, its current owner resuscitated the old brand and formula and re-introduced it to the market. Schlitz is in test phase now, mostly in selected mid-west markets, and its popularity sounds an echo of its former prominence. The story of the rise and fall of Schlitz offers lessons for us, even today.

The Joseph Schlitz Brewing Company was just one of many brewers in Milwaukee in the late nineteenth century. It became a top seller only after the great Chicago fire of 1871 wiped out its Chicago competition. The failure of other brewers gave Schlitz its opening to become a leader in the market. Here is the first lesson. It didn’t “win” its market. It gained its top billing because it was one of the last brewers standing at the time. The failure of a competitor is the source of most share gain in many of the markets that exist today. (See “Failure Shifts More Share Than Success” on

In the early years of the 20th century, Schlitz entered its halcyon days. It was the world’s best selling beer for most of the first fifty years of the 20th century. Then, in the mid-1950s, the Milwaukee brewery’s workers interrupted production with a strike. The Schlitz product was scarce on the shelves and other competitors, such as Anheuser-Busch with its Budweiser brand, filled the gap. Budweiser and Anheuser-Busch have held the leading position in the U.S. market since that time.

Here we have a second example of the observation that failure is more likely to move share than is a “win”. Budweiser could not take share from Schlitz as long as Schlitz was readily available on the market. When Schlitz was not available, Budweiser gained share. Then Schlitz had to wait for Budweiser to “fail” before it would gain that share back. Budweiser didn’t fail.

In today’s market, the pilot’s union at United Airlines could learn from this lesson. Their occasional work actions to interrupt service for their employer, United Airlines, has caused that company to cancel several hundred flights. Great idea. Create failure for your employer in the marketplace. Allow others to pick up share that United would have held. Create a smaller airline with lower profits. Have fewer pilots and less revenue available to pay all employees, including the remaining pilots. Where do these pilots learn their economic history?

On with the Schlitz story. Schlitz remained a vibrant and profitable competitor, even after losing its leading share position to Budweiser. In 1970, it still had 12% of th market, compared to Anheuser-Busch’s 18%. Later, in the 1970s, new owners took over the business with the intention of expanding it. In order to do so with little investment, the owners shortened the fermenting process. They also had quality control problems with some of their ingredients that caused the beer to lose its taste. There was a lot of that poor quality beer out in the marketplace. But rather than recall it and correct the situation, the owners decided to weather the storm and sell the defective product in order to create more near-term profits. With this Reliability failure, customers abandoned the brand. By 1981, the Schlitz brewery closed and the Stroh’s Brewing Company from Detroit bought the brand. Stroh’s also struggled and became part of Pabst Brewing Company in 1999.

So we have another lesson from the history of Schlitz. If you fail in Reliability you are in real trouble. The first success of Schlitz came from others’ failure in Convenience. Schlitz had product when others did not. The first failure in the 1950s also came as a result of a failure in Convenience. The product was not available to meet demand. But the most devastating failure was the last one. That was a failure in Reliability. The company delivered a very poor product to customers that had long trusted it to be consistently tasteful. Things like that can be unforgivable. In this case, the Reliability failure was fatal.

So, good luck to the new Schlitz. Let’s hope it learns the lessons of its past and consistently delivers good quality beer in the future.

Monday, August 18, 2008

Will a Silver Strategy Work for United?

Recently, United Airlines announced that it would reduce its service to some of the biggest cities it serves and shift assets to the service of smaller cities. Big cities like Nagoya, Japan and Chicago will lose some service, while cities like Grand Rapids, Michigan and Gillette, Wyoming will gain service.

We have seen this before. In the very early years after airline deregulation, Piedmont Airlines stepped back and watched the largest airlines in the country rush past them to serve the largest cities in the U.S.: New York Chicago, Los Angeles, and so forth. Once the crowd had blown by, Piedmont initiated service to smaller cities, where there was less competition and higher prices. This strategy proved to be very successful for Piedmont. For several years, it enjoyed high profits and a sterling reputation.

So, can United pull off the same strategy? Unlikely. Really, the airline isn’t trying to use a Silver strategy exclusively. Piedmont was a small competitor in the marketplace. TWA, Eastern, American, United, Northwest and Delta were all larger. It had little likelihood of head-to-head success against these larger carriers. Instead, it chose to follow a pattern of competition that has proven successful time and again for smaller competitors. We call this a Silver strategy. (See “Rare Mettle: Gold and Silver Strategies to Succeed in Hostile Markets” in StrategyStreet/Tools/Perspectives.) Part of this strategy is to focus service on segments of customers where there is less competition and where average unit prices are higher. These are always smaller market segments.

This strategy is not appropriate for United. As the number two carrier in the country, it can not succeed in building a Silver strategy without destroying itself in the process.

On the other hand, United is not trying to follow a Silver strategy exclusively. It wants to take advantage of a market that Silver competitors would naturally serve. United is tweaking its strategy on the margin to serve smaller cities with less competition and higher prices per seat mile flown. This set of new markets will complement, rather than replace its big hub and spoke network.

These changes will help, but not save, United. United’s big problem is that it remains a high cost producer in the marketplace, even against some of its large competitors. Until United can stand toe to toe with low cost competitors on equivalent routes, it should continue to weaken in the marketplace. Whether it can do that eventually is as much in the hands of its unions as it is in the control of management. Not promising. See the history of the domestic steel industry.

Monday, August 11, 2008

How the High End Company is Vulnerable

The housing market is in a shambles, especially the new home construction market. In partial response to this horrible market, some of the home building industry’s largest competitors, including Toll Brothers and Hovnanian Enterprises, have entered the custom home market. Their entry illustrates the strengths of companies at the high end and exposes their vulnerability.

In the custom home market, small builders design and build homes for customers who own their own lots. These customers go to these high end builders because of Function. The builders will design and build exactly what the customer wants. The Features and Functions of the home are precisely built to the customer’s specifications. (See “How Customers Buy” in We call companies at the high end of the product spectrum Performance Leaders. These companies usually offer Functions that the industry’s largest competitors, whom we call Standard Leaders, do not offer. (See “Success Under Fire: Policies to Prosper in Hostile Times” in

There is not much of a market for the Standard Leaders in home building today. New home construction rates are near historic lows. In search of some market, then, these Standard Leader builders have begun offering custom-built homes. There are two types of these homes: semi-custom homes, which are developed from the builders’ pre-drawn plans; and custom homes, which are built to the buyer’s specific specifications. The Standard Leaders are entering the Performance Leader’s territory with both semi-custom and custom homes.

Why would a custom home customer buy a Performance Leader product, such as a custom home, from a Standard Leader company? There are three answers to this question. The first answer is that the customer wants Reliability. These customers want to be sure that the project will be finished as promised. These Standard Leader builders have more resources available to them and have a proven capability to complete a project, where sometimes Performance Leader builders might falter. Second, the customers for the custom home buy on Convenience. Some of these customers have found that the Standard Leader builders can produce a custom home in half the time it takes for the Performance Leader builder to complete the project. Finally, these custom home customers also buy on Price. The economies of scale that the Standard Leader builders can bring to the Performance Leader product category enable them to offer lower prices, per square foot of home. In fact, these prices can be as much as 25% below those of the Performance Leader custom home prices.

Performance Leaders are usually strong on Function. But Standard Leaders can attack their market, offering better Reliability, Convenience and Price. The Standard Leaders’ high end product is “almost as good as” that of the Performance Leader company’s product, but it is much cheaper.

This Standard Leader attack from below pattern has recurred many times. Another example is the Lexus line of automobiles offered by Toyota. In the early years of Lexus’ debut, Toyota priced the Lexus at a breathtakingly low price compared to its competition from Mercedes and BMW, among others. This price advantage shot Lexus into the market. Today, the Lexus enjoys a much higher price level but it is still less expensive than BMW or Mercedes.

Thursday, August 7, 2008

Consolidation in the Waste Industry

The leading waste management company, Waste Management Inc., has just offered to buy the number three ranked competitor, Republic Services. This offer preempts Republic’s offer to purchase the number two competitor in the industry, Allied Waste Industries.

Before these acquisitions, the waste industry was about average in its degree of consolidation. The three largest U.S. waste companies control about two-thirds of the nation’s permitted landfill capacity. In the average large industry, the top three competitors have about 68% of total industry sales (see the Tools/Benchmarks/Quartile Ranking Reports/Marketshare in

If Waste Management’s offer is successful, it will then control 50% of the country’s permitted landfill capacity. This 50% compares with the median industry leader among large industries with a market share of 38% of sales. This is a very strong position.

Monday, August 4, 2008

GM in a No Win Position

You have to feel sorry for the beleaguered leaders of General Motors. The company is suffering through a perfect storm. Automobile sales this year will be fourteen million units, down from the sixteen million the company had expected. Down even more are sales of large SUVs and trucks, on which GM had pinned its hopes for profitability and cash flow.

The company is now down to about six months of certain liquidity. After that, there is great uncertainty.

The company has announced new rounds of lay-offs and restructuring to enable the firm to return to profitability. These plans are unlikely to be successful for one simple reason: GM’s problem is not just the current costs of producing an automobile or a truck. The company is hemmed in by fixed costs of servicing a unionized and white collar retiree group with benefits negotiated during a time when GM was a much bigger, and more successful, company. There are various estimates for how much these fixed costs are, ranging from $1000 to $1500 per automobile.

GM can not hope to overcome this disadvantage at its present size. It is competing in a market with very efficient Japanese competitors, unburdened by these high fixed costs of retirees. So, even assuming that GM could reach the same cash costs of producing a world-class automobile as can Toyota and Honda, that still leaves them well short of the amount the company needs to pay for retiree benefits. The company is gradually being dragged under by old promises that even it can no longer meet.

GM is cutting costs where it can save cash today. Inevitably, some costs will go at the expense of customer benefits, in features, reliability or convenience. This can only make worse the first problem GM faces, a value proposition, its performance for price, that customers deem unworthy. (See our July 7, 2008 blog: "Value in Two Hostile Industries".)

Thursday, July 31, 2008

Economies of Scale at Work...And Not

Economies of Scale are important, at least in the minds of many managers and investors. Often, we can see these Economies of Scale at work in powerful ways. Sometimes, they seem to disappear.

Within an industry, Economies of Scale tend to be greater from one competitor to another when the industry has high growth. As an example, consider software companies. Oracle Corporation has found that software companies with annual sales of $250 million to $1 billion have operating margins of about 10%. This means that these companies spend 90% of their revenues on costs of People, Purchases and the Capital costs of depreciation. When the size of the companies increases to $1 billion to $5 billion in sales, operating margins go up to 16%. These companies spend only 84% of their revenues for People, Purchases and the Capital costs of depreciation. The largest companies, those with more than $5 billion in revenue, include Oracle, SAP, Microsoft and IBM, a group in rarified atmosphere. These companies have average operating margins of 30%, spending only 70% of their revenues on People, Purchases and Depreciation. Economies of Scale are quite high in this fast-growing industry. (See Steps 27 thru 29 of the Basic Strategy Guide on

Now consider an industry that is actually shrinking in physical units sold. Here we will measure Economies of Scale by the number of employees required to produce and deliver one thousand shipments. The leading company in the industry requires 4.5 employees to produce these one thousand shipments. Another major competitor in the industry is less than one quarter the size of the leader, but this company can provide a thousand shipments using about 5 employees per thousand. The smaller firm requires about 11% more employees per thousand shipments than does the much larger company. This contrasts with the roughly 30% more people required by the smaller companies than the largest companies in the software business.

You can also see Economies of Scale at work in an industry over time. You can see it as the industry grows and reduces its costs and consequent prices. A good example is the U.S. cellular service market. In 1997, cellular service cost about 42 cents per minute and customers bought 105 monthly minutes per subscriber on average. By 2004, after much growth and consolidation in the industry, a minute of cellular service cost about 13 cents and the average customer purchased 280 minutes per month. Costs dropped substantially due to Economies of Scale.

Economies of Scale are not a sure thing in many markets. In fact, the leading company in an industry, more often than not, has a Return on Investment lower than that of a smaller competitor. (See the Perspective, “Is Bigger Really Better” on Economies of Scale are the result of strenuous management efforts, not the gift of size alone.

Wednesday, July 30, 2008

The Fate of Price Point Specialists in Hostility

As a market works its way through overcapacity and Hostility, the industry’s Price Point specialists come under extreme pressure.

Often, the low-end competitors, we call them Price Leaders, are squeezed out by the industry leaders, whom we call Standard Leaders, introducing low-end products to their product line. This pattern explains the demise of low-end automobile manufacturers, such as Yugo and American Motors. The high-end Price Point specialists, whom we call Performance Leaders, also tend to suffer. The industry Standard Leaders introduce more high-end products and pull enough volume from the Performance Leaders to cause them economic hardship.

Many of the Performance Leader companies are purchased by Standard Leaders over time. An example is Ford’s purchase of Volvo and Jaguar when Ford was still a strong Standard Leader. Today, the Japanese automobile manufacturers set the standards for the auto industry. They offer products at most price points, from Price Leader to Performance Leader, and present a strong challenge both to other Standard Leaders and to the remaining independent Performance Leaders in the automobile industry. (See “Why Do Leaders Lead?” in

Even the airline industry is starting to see pressure on the Price Leaders caused by Standard Leader cost-cutting. Until recently, the Price Leaders in the industry, such as Jet Blue, Virgin America, Air Tran and even Southwest, had been protected by the onerous work rules that the unionized workforce imposed on the legacy carriers. But bankruptcy, or its threat, enabled the legacy carriers to reduce some of their cost disadvantages. Now even the best of the Price Leaders in the industry feel the sting of intense competition. At the other end of the price spectrum, no Performance Leader airline in the industry has survived more than a very few years during hostility. All are now gone.

Thursday, July 17, 2008

International vs. U.S. Growth

Recently, CIBC World Markets’ Jeff Rubin, who is Chief Economist, and Avery Shenfeld, a Managing Director, produced a slide show called “The Age of Scarcity.” To see the slideshow in full, click here.

This slideshow helps me understand why my domestic and Europe investments are off so much more this year than my investments in emerging markets. Among the surprising findings are the following:

  • The U.S. is responsible for only 10% or so of global GDP growth, the Euro zone for about 8%. But the emerging markets, including Brazil, Russia, India, China and the mid-East oil producers are responsible for 37%.

  • All the major regions, including the Euro zone, Latin America and emerging Asia are much less dependent on the U.S. market for exports than they were in 2000. For example, in 2000 the Euro zone depended on the U.S. for 17% of its exports. Now it is something just north of 13%. As a result, a two percentage point decline in U.S. GDP growth would produce declines of half a percent, or less, in many of our trading partners.

  • While U.S. demand for aluminum, nickel, copper, zinc and oil has declined during the period of 2005 to 2007, the demand in China has increased substantially. In aluminum, its demand has grown by 30% over that period of time.

  • While U.S. and Europe are seeing minimal growth or shrinkage in their rate of automobile ownership, Russia and China are growing at rates over 50% and 20% respectively.

Of course, domestic and European companies with a high proportion of their businesses in growing markets can do well despite slow conditions in their home markets. For example, in the U.S., Celanese Corporation is operating at record rates, with high profits, due to its strong positions in fast-growing Asian markets.

Overall, these developing markets are a growing force in the growth of larger companies. To be a successful long-term player, you have to sell where the growth is. See Basic Strategy Guide Step 6 in