Monday, June 29, 2009

Two Pathways to Low Cost

There are two pathways to low cost: Focus on particular customers and their product needs; or create economies of scale. When you combine both, you have a powerful low-cost engine that is also attractive to customers.

Several years ago, I consulted for a high tech company. This company sold components for a much larger technology system. The company’s customers were many times the size of my client. Most of the technology system companies who could have been my client’s customers produced their own component rather than purchasing from a merchant outside supplier like my client.

I asked my client CEO how he expected to out-perform the in-house competitors he faced in the marketplace. He had to be at least as good, if not better, in Function, while being lower in Cost and Price. His answer was focus. His company did nothing else but produce this component. Everyone in his company focused their attention on improving the component and reducing its cost. He argued that his in-house competition did not have the same advantages of focus that he had. His focus would produce lower costs and prices, which would be visible to these larger companies over time. Then his business would grow very rapidly.

I was reminded of this story while reading of a study done by Forrester Research. This study explains some of the changes happening in the outsourcing market.

Several Western companies who had opened centers in India to perform back office work in a cost-saving move have now sold these operations. Several of these companies had decided early-on that they could save the 15 to 20% profit margin that Indian outsourcers typically charge by building their own centers. In many cases, this has proven to be a false economy.

The Forrester Research study estimated that it cost about 25% more for a company to operate a captive center in India rather than to have an outside company provide the same services. In other words, the outsourcing company is able to create a profit for itself that allows it to finance and grow its business, and still charge prices 25% below the costs of the captive center. (See Audio Tip #182: Productivity as a Measure of Physical Costs on

How can this be? The answer comes in noting the buyers of these centers. (See Diagnose/Costs/Quantifying Cost Reduction Objectives on In virtually every case, the buyer of these centers, which western companies are closing, are large Indian outsourcing firms, such as Wipro Ltd. (See Audio Tip #196: Why Economies of Scale Exist on As these Indian outsourcers purchase the centers from the western companies, they gain two important benefits. They acquire experienced employees and guaranteed contracts from the western companies extending for a period of years. These Indian acquiring companies then have the benefit of both focus and economies of scale. This combination will make them an even stronger presence in the market.

Thursday, June 25, 2009

Health Care Costs - Our Future

The debate is about to rage over healthcare costs and coverage. So, what might our future look like?

Let me preface this blog entry with the note that I, personally, believe that healthcare should be available to all of our people. What I will question here is the assumption about the effectiveness of what we are about to do, not whether the ends are worthwhile.

We are about to extend healthcare coverage to 47 million people who are currently uninsured. This 47 million figure is a little over 20% of the population below the age of 65, where Medicare and Medicaid cover health insurance. This is a substantial increase in demand.

By definition, the supply today equals the demand. (See Diagnose/Pricing/Industry Price Outlook on In somewhat longer version, this is an equation:

Units of Supply X Cost per Unit = Units of Demands X Price Per Unit

If demand increases, either supply must increase or unit costs must fall, in order to keep the equation in balance. If neither supply increases nor cost productivity improves, then price must rise or demand must be forcibly reduced. We reduce demand by rationing.

There are a number of plans to change our healthcare system in addition to extending the system to 47 million new customers. The government plans to:

* Bar insurers from excluding sick people, an increase in the cost of supply.

* Create a national insurance exchange where people could shop for different plans. One of the plans would be a public plan, like the one that covers Federal workers. This is not really an increase in supply. This new exchange is equivalent to an insurance company. These are agents intermediating between buyers and sellers. There is no increase in healthcare beds or workers in this plan. Rather, it is an increase in the cost of the current supply as we pay for a new government bureaucracy.

* Use information technology and “evidenced-based medicine” to reduce the cost of service. This is a potential real cost savings, if doctors will go along.

* Allow the import of drugs from countries where they are cheaper because they are the result of government negotiations with the U.S. drug firms. There is some chance this could reduce cost because it may force drug companies to demand more payments from foreign governments. This is not a real reduction in the cost. Rather, it is a change in who, in theory, will bear the cost. This may or may not work for the U.S. consumer.

In sum, from the initiatives we have noted, there is a high likelihood that the total cost of supply will rise, even as demand increases by over 20%. But it may be worse than that.

The government financed plan option may drive some of the current insurance companies out of the market. The insurance companies, as private firms subject to stringent public market accounting demands, must account for their long term liabilities under the insurance plans they offer. The government, as we have seen with Medicare and Social Security, is under no such requirement. Without the need to provide for the real long-term cost of the healthcare insurance, it is likely that the government will under-price the cost of the insurance it will offer as an agent. As a result, some of the current agencies, that is, insurance companies, may have to leave the market. This will shift more costs to a government bureaucracy like the one we have in Medicare. Again, the outlook for costs is bleak. Where has the government ever been more efficient as a cost manager than has the private sector?

Returning to our supply/demand equation above, there seems to be very little hope that the cost of future healthcare will fall, or even remain steady, as demand increases. Prices are likely to skyrocket. An alarmed government must then ration healthcare to bring demand into balance with supply at some acceptable price.

However, there is something missing from the discussions to date. Why is there no discussion of an increase in supply that would help alleviate the cost and price pressures, while at the same time, providing more relief to the about-to-be-super-heated demand?

It appears that we could increase supply with a bit more political will. In particular, we could increase the number of doctors over the next few years. In 2007, in the United States, there were 42,000 applicants for medical school. Only 18,000 places were available for these applicants. 57% of our applicants did not find a place in a U.S. medical school. Our political process has restricted the supply. It does take a lot of capability and training to become a doctor. It also takes a lot of ability and training to become a proficient engineer, lawyer, college professor and professional scientist. Do the day-to-day requirements of our medical doctors justify the restriction of the supply that the political system has put on the places in medical schools?

Monday, June 22, 2009

New Product in a Fast Growing Industry: Verizon Cloud Computing

Verizon Communications recently announced that it was entering the market for cloud computing. Cloud computing is a service that allows a business to increase its computing power by using the internet, network bandwidth, on demand, from facilities operated by companies like Verizon. This market is fast-growing because it allows businesses to save the costs of building and managing their own computer facilities. Let’s use the Customer Buying Hierarchy to evaluate the prospect for Verizon’s success.

The Customer Buying Hierarchy (see “Video 27: Full Description of How the Customer Buying Hierarchy Works” on holds that customers buy a product using four categories of evaluation: Function, Reliability, Convenience and Price. Function (see “Video 13: Definition of Function” on refers to the features of the product that affect how it is used. Reliability (see “Video 14: Definition of Reliability” on refers to the benefits of the product that assure the customer that it works and will continue to work. Convenience (see “Video 15: Definition of Convenience” on refers to the ease with which the customer may find and purchase the product. Price is the cash cost the customer pays for the product.

Verizon offers a valuable Function advantage. Cloud computing is a service that today is targeted at large corporations. These corporations use several different types of computers and software applications. Verizon has made a Function innovation leap by offering customers options in setting up their cloud service that would include being able to use various types of computer servers, depending on the software applications the business needed to use. But this is early in the game, so many Function innovations have yet to be introduced.

Verizon, along with its telecom competitor AT&T, does have some real Reliability advantages. These companies have spent years managing network services, data infrastructure and transfer. (See the Perspective, “Reliability: The Hard Road to Sustainable Advantage” on This gives them real credibility with corporate customers. Verizon and AT&T also have a significant Convenience advantage in their global reach. (See the Perspective, “Convenience: Much Tougher Than it Looks” on These two phone companies are able to offer cloud services to overseas divisions of companies.

Pricing is the great unknown. Low prices can move a lot of share in a fast-growing market. Neither Verizon nor AT&T are what you would consider sharp pricing companies in their other businesses. It is unlikely, then, that they will be aggressive price competitors. On the other hand, Amazon also plans to enter this marketplace. Amazon has learned to compete aggressively on Price and may be the eventually price-setter in the market.

This is very early in the development of the cloud computing market. Unique Function advantages may emerge and remain unique due to legal barriers. The early Reliability and Convenience advantages strongly favor Verizon and AT&T with their technical competence, corporate reputations, and global reach. One, or both of them, should be very successful in cloud computing, assuming that they don’t get tripped up with high prices.

Thursday, June 18, 2009

New Product in a Fast Growing Industry: Bing

After failing more than once to create an innovative and attractive search product, the persistent Microsoft is back with a new entry called Bing. Let’s use the Customer Buying Hierarchy to evaluate the prospect for the Bing’s success.

The Customer Buying Hierarchy (see “Video 27: Full Description of How the Customer Buying Hierarchy Works” on holds that customers buy a product using four categories of evaluation: Function, Reliability, Convenience and Price. Function (see “Video 13: Definition of Function” on refers to the features of the product that affect how it is used. Reliability (see “Video 14: Definition of Reliability” on refers to the benefits of the product that assure the customer that it works and will continue to work. Convenience (see “Video 15: Definition of Convenience” on refers to the ease with which the customer may find and purchase the product. Price is the cash cost the customer pays for the product.

We will begin with a look at Function differences. The search industry has two customers: The consumer searcher and the advertiser. This new Microsoft entry is drawing some good reviews for consumers and some wait-and-see opinions from advertisers. Bing offers some new Function innovations that reviewers prefer to Google’s search results. It appears that the consumer will find Bing an improvement on Google. The advertisers, however, are adopting a wait-and-see attitude. Google’s market share, at over 60% of the current search market, is massively larger than is Bing or its Microsoft predecessor. Even Yahoo Search is much larger than is Microsoft in the market. Many of these advertisers plan to wait to see whether Bing will become the new Google.

The Reliability and the Convenience advantages in this market belong solely to Google. The company name has become a verb describing a search. Most people know about the Google product and believe it to be the market leader. A large percentage of desk top and lap top computers have the Google toolbar with its search box resident on their computers. Google is an easy default choice for most searchers.

So, what is the outlook for Bing? The success of Bing largely depends on what Google does to respond to the Function advantages Bing is bringing to the market. This is still a fast-growing market. This works in Bing’s favor. Consumers are likely to be willing to try something new if they think it might help. Switching to Bing from Google or Yahoo offers little difficultly. Microsoft has the cash to put on quite a marketing blitz. All of these Convenience factors work in Bing’s favor. However, Microsoft has to rely on the forbearance of competitors in order to win in this marketplace. It has to maintain its unique Functions in order to best Google in a world Google dominates. (See the Perspective, “When to Compete on Features” on If Google copies Bing’s new Functions, Bing will lose its advantage and will not succeed. The Reliability and Convenience advantages that Google enjoys today give it time to copy Bing’s Function advantages without losing much of its current market share.

If Google neutralizes Microsoft’s Function advantages soon, Bing will bring only modest market share changes.

Monday, June 15, 2009

New Product in a Fast Growing Industry: The Pre

The mobile phone hand set industry is fast growing, especially the segment known as smart phones, which combine the functionality of a limited PC or a good PDA with the normal telephone hand set functions. The new Palm Pre is entering this market. Let’s use the Customer Buying Hierarchy to evaluate the prospect for the Pre’s success.

The Customer Buying Hierarchy (see “Video 27: Full Description of How the Customer Buying Hierarchy Works” on holds that customers buy a product using four categories of evaluation: Function, Reliability, Convenience and Price. Function (see “Video 13: Definition of Function” on refers to the features of the product that affect how it is used. Reliability (see “Video 14: Definition of Reliability” on refers to the benefits of the product that assure the customer that it works and will continue to work. Convenience (see “Video 15: Definition of Convenience” on refers to the ease with which the customer may find and purchase the product. Price is the cash cost the customer pays for the product.

In Function, the Pre performs well. In a high-growth industry such as smart phones, product innovation, especially in Function, is the name of the game. The Pre does not disappoint here. It offers a number of Function innovations, some of them unique to the Palm Pre, to entice customers.

The Reliability and Convenience nods go to Pre’s competitors. Research In Motion’s BlackBerry dominates the corporate market while Apple’s iPhone controls the consumer market in smart phones.

Price appears not to be a competitive issue in this market. Apple learned with its experience with the original Apple computers, and then with the Mac, that it can not charge high prices and hope to be the largest competitor in the market. Apple became a shrewd maket-pricer with the iPod. It continues its smart ways with the iPhone. The key price point for smart phones today is $200 and the major competitors all seem to offer a strong product at that price point. Any price reduction at this price point is likely to elicit an immediate response from the other competitors. In addition, any new, lower, price point for the smart phone is also likely to be matched by the other competitors in the marketplace. (See our Blog on the $99 iPhone.)

Can the Pre win on its Function advantages? The key Function innovations in this market will save customers time. Styling may bring some early customers, but differences in style are likely to be minimal in customer decisions. New applications, though, are critical. These really do save customers time and, therefore, costs. Here the current advantage clearly rests with Research In Motion and Apple, both of which have a large number of third party applications available for their phones. Apple has more than 35,000 apps available for its current phone. Even Google’s Android operating system has nearly 5,000 apps available. The Pre has a long way to climb to match the Function advantages that third party apps confer on the incumbent competitors..

While this is a very fast-growing market, the Pre is coming late to the game. Palm has to hope that their major competitors will not copy the Functions that are unique to the Pre. Then they have to hope that app developers will fall in love with the Pre and its operating system and write many new programs for the new phone. These are possible, but not probable developments. Since smart phone pricing is unlikely to be potential point of advantage for any of the current competitors, the outlook for the Pre is not strong. It may attract a relatively small segment of the market, but it is unlikely to become the industry leader in smart phones. (See the Perspective, “The Dangers of Competing on Features” on

Thursday, June 11, 2009

Apple Flanks its Phone Market

Apple continues to impress with its moves in the smart phone market.

On the one hand, the company did as we might expect. It introduced a new iPhone with more functions, but priced to compete with the other competitors, at about $200. In a fast-growing market such as the smart phone market, Function innovation (see “Video #31: Function Innovations” on drives significant changes in market share as long as these innovations are not copied by competitors.

On the other hand, Apple did something that is not characteristic of high-end leaders. The smart phone market is a high-end, Performance Leader, market (see “Video 20: Definition of Performance Leaders” on The average Performance Leader competitor is loathe to introduce a much-lower priced product to compete with its Performance Leader standard bearer. But, Apple did just that. It reduced the price on its original, highly popular, iPhone to $99. Both the price and the concept are very good.

In a fast growing market, low price, more specifically, a new low price point, can also move a lot of market share. The old iPhone now costs 50% less than the new iPhone. Apple has created a lower-lend price point to protect itself from an attack from below. On average, a price point 25% or more below the product standard will attract a lot of current customer attention. A price point 50% below the most popular industry product will do the same and bring new customers into the market. By reducing the price of the old iPhone by 50%, Apple has created a product that will rapidly expand the total market for smart phones, and Apple will have the majority of these new customers.

This new customer volume from the reduction in price on the old iPhone should ramp up Apple’s economies of scale for all of its iPhone products. If Apple’s economies of scale improve, so will its overall margin structure. This superior cost position will enable Apple to gain even more share in the future with similarly aggressive pricing.

This new $99 price point can not go unanswered by the other smart phone competitors (see “Audio Tip #106: How do we Predict Competitor Responses to our Price Moves?” on There will be too much new market share there for them to ignore this price point.

Monday, June 8, 2009

How 'Bout We Throttle This Golden Goose?

Now that GM has entered bankruptcy, there are many opinions crossing the wires about the likelihood of the new GM being a successful stand-alone company. I thought I might as well add to this crowd noise.

First of all, let’s consider the problems that caused the bankruptcy. The first, and least forgivable, cause was the management team. The management team, some years ago, gave away the store to the UAW. They promised wages, benefits and work rules that were non-competitive in the world market. They agreed to numerous, costly work rules, high wages, generous time off and extensive retiree benefits. Once they had made these concessions, management was afraid to face the prospect of a long strike that might have recaptured some of the company’s cost competitiveness. Effectively, labor costs became fixed.

The second source of the problem was the UAW or, more specifically, the leadership of the UAW. Once labor costs became fixed, they “owned” the golden goose called GM. They have watched for years as GM gradually ebbed away because of the high costs that the union contracts imposed on the company. They stuck to unbelievably ill-advised programs like the Jobs Bank, even while GM was hemorrhaging losses. Tell me. What did the leaderships of General Motors and the UAW study at school that led them to conclude that they could withstand an uncompetitive cost structure on the world stage? Who teaches that economics course?

Once management realized that it had put itself in an untenable cost position, it made changes to its products in order to reduce all the other costs of the product, other than wages. (See Video #47: Rules for Cost Cutting in Hostility on Among these changes, the company created look-alike cars across its various platforms. It reduced the quality of its finished product so that the company developed a reputation among consumers for poor workmanship. This reputation caused the resale value of GM cars to fall below those of its international competitors and raised the cost of ownership for its customers. In another similar move, the company cheapened the interiors of its automobiles so that a customer sitting in a GM car found its quality of finish well below that of its competition. All of these, of course, were self-defeating cost reductions. This is a common phenomenon in tough markets. Common, but destructive. These changes caused GM to see its market share fall by about 1% a year for many years. The further the company’s market share fell, the more onerous was its labor cost structure with its high fixed costs.

So, O.K., the company has entered bankruptcy and most of its investors have suffered disastrous losses. Will GM emerge as a successful company? After all, the UAW has surrendered some of its high wages and some other rights, especially the right to strike for the next several years. And, the UAW is now a major owner of the new General Motors.

We have seen this movie before, however, with United Airlines. The labor unions, especially the pilots’ union, became major shareholders of United Airlines in trade for wage growth, as that company sought to restructure in order to reduce its cost structure. Union members in the airline industry, though, quickly figured out that a dollar of wages was worth a lot more to the union member than was a dollar of profits to all shareholders. High and uncompetitive wage demands continued, despite the fact that United Airlines was losing both market share and profits. Eventually, the pilots demanded, and won, such a high level of compensation that United Airlines slipped into bankruptcy. So much for the benefits of union ownership.

There is a simple test to determine whether GM will be successful as a stand-alone company. It is not a test of management capability or will. It is more a test of the insight that this saga of destruction has brought to the leadership of the UAW. The current contract between the UAW and General Motors is the size of a telephone book. If the company and its key union end up with a contract more the size of a college term paper, the odds of success are high. If the contract remains the size of a telephone book, we tax payers can plan to spend a whole lot more money on GM for a lot more years. It won’t succeed as a stand-alone company.

Thursday, June 4, 2009

Competing Against Low-End Competition

The consumer food industry has both an opportunity and a challenge in today’s marketplace. The opportunity comes as consumers reduce their “eating out” occasions and, instead, eat at home more frequently. The challenge is the seemingly inexorable market share growth of the less-expensive private label products. Some of the responses of the packaged food industry to these opportunities and challenges give us some insight into how to compete with low-end competitors and offset the ravages of a tough economy.

Several of the branded food companies are instituting advertising programs emphasizing the value of their products compared to alternatives. They hope to increase their share of the growing eat-at-home market by emphasizing their good value. Oscar Mayer Deli Fresh Meats claims that they have deli fresh taste without the deli counter price. Lean Cuisine Frozen Foods claims that its products are good for the wallet. These companies are helping the consumer to see a cost advantage to the use of their branded foods in a difficult economy.

Competing with private labels is proving somewhat more difficult for the industry leaders, whom we call Standard Leaders. (See the Symptom and Implication, “The industry leaders are losing share” on Some Standard Leaders argue that they offer better quality than cheaper alternatives. Others are responding directly to the low price challenge of private labels by discounting their products. Actually, relatively few branded food companies are discounting their products directly. Instead, several are offering discounts in kind. In this form of price discount, the company offers more product for the same price as the previous version of the product. Frito Lay is adding 20% more product to some of its snacks without increasing the prices. French’s is selling a 20 oz. bottle of French’s Classic Yellow mustard for less than a 14 oz. bottle.

Other companies assert the simple claim that their food is not expensive. A joint advertising venture between Chips Ahoy cookies and Capri Sun juice explains that a serving of the two snacks costs about a dollar. Del Monte argues that a consumer can stretch her food dollars because canned foods offer better value than frozen or fresh foods. Kraft Singles cheese slices claims that a Single’s cheeseburger costs less than a dollar.

Over the years, we have studied several hundred low-end competitors. We have analyzed how the industry Standard Leaders respond to these low-end challenges. We have concluded that there are four different types of low-end competitors: Strippers (some private label products), and Predators (most private label products) who are players who just offer low prices. The other two types of low-end competitor offer better performance as well as a lower price. The response to each of these types of low-end competitors depends on several factors in the marketplace.

In summary, we found that the Standard Leader responses to these low-end competitors fall into patterns. The ideal order of these responses would minimize the impact of the response on the company’s margins, as follows:

1. Ride out the challenge. The Standard Leader company does not change its own value proposition in response to the low-end challenge. Instead, it:

• Ignores the low-end competitor where the competitor cannot expand
• Blocks the low-end competitor by using legal challenges and control of information, among other means
• Acquires the low-end competitor

2. Improve the value proposition. The company strengthens its own value proposition to make itself more attractive to customers in the face of the low-price challenge. It:

• Adds a low price point in the marketplace
• Increases its current product’s benefits without increasing prices
• Reduces its prices, as a last resort

In order for a response to succeed, the Standard Leader company must ensure itself that its response will discourage future challenges and leave it better off than it would have been without the fight. (See the Perspective, “Turmoil Below: Confronting Low-End Competition” on for much more detail on how to compete with low-end competitors.)

Monday, June 1, 2009

Another High Profit Industry Comes Under Assault

For many years now, large employers and governments have contracted with pharmacy benefit managers (PBMs) to provide and administer drug coverage for their employees. In turn, the PBMs tell the employers that they will pass on a good part of their purchasing economies to save the employers’ cost. This approach has worked well for the PBMs for years. They have been highly profitable businesses.

These high profits have attracted the attention of a new scary competitor, Wal-Mart (see “Video #3: Predicting the Direction of Margins” on Wal-Mart is offering businesses low-priced drugs if they sign up to have their employees purchase directly from Wal-Mart’s network of in-store pharmacies. Wal-Mart will offer these businesses a fixed mark-up over its cost for the drugs. While Wal-Mart will not reveal the cost of its purchases, it will have a third party verify the mark-up, thus guaranteeing the business of its deal. Wal-Mart benefits in two ways with this new business program. It guarantees a profit on each sale with its cost plus pricing. It also draws more customers into its stores where it has a chance to sell them other products.

This Wal-Mart product innovation follows on the heels of a similar consumer program they introduced some time ago. In this latter program, Wal-Mart introduced a $4 per subscription generic drug program for consumers. This drug program forced the entire retail drug industry to offer discount plans and it lowered the cost of drugs for consumers.

Wal-Mart is a discounter (See “Video #21: Definition of Price Leaders” on Will it succeed with this new business-oriented program? A discounter is likely to succeed if it can attract the largest customers in the market place. We call these Very Large customers. Wal-Mart has already attracted one of those very large customers in Caterpillar Company. Caterpillar has purchased drug coverage for 70M employees and their dependents through Wal-Mart. This customer has been so pleased with its savings in the drug benefit program that it has waived co-payments on generic prescriptions that its employees purchase from Wal-Mart. This, of course, makes the Wal-Mart program even more attractive to the employee because it is cheaper than any other alternative available.

The forecast? Costs down for businesses. Lower profits and growth for PBMs. (See the Symptom and Implication, "The industry leaders are losing share” on