The StrategyStreet Blog

Benefits of Intense Competition: Lower Prices and Better Products

2011-08-16T17:06:00.000-07:00

No segment of our economy has been under more intense pressure than the manufacturing sector. Lower labor costs in many parts of the international economy have forced manufactured product prices down and shifted manufacturing jobs out of the United States. Competition has indeed been intense.

Over the years, we have done in depth studies of more than fifty industries who have faced intense competitive markets. We found both what you might expect and, also, what you wouldn’t expect. You would expect that costs in a difficult industry would fall as companies work to make a profit despite the falling prices that accompany intense competition. What you might not expect is that product quality and supporting service levels increase at the same time as costs and prices fall. Customers simply will not buy a poor product even if its pricing declines.

The broad measures of the manufacturing sector illustrate these same conclusions. Manufacturing in the U.S. is finally growing again. In 2010, manufacturing jobs increased for the first time since 1997. Today manufacturing is growing at three times the rate of the domestic economy. Consider, as well, the following facts as noted by Jerry Jasinowski, a former President of the National Association of Manufacturers:

American exports of goods rose 21% in 2010. Conclusion: the quality of our goods is rising.

Manufacturing output in the U.S. today is twice that of the rate of the 1970s, in real terms. Conclusion: we are more cost competitive today than we were in the 1970s.

Between 1987 and 2008, manufacturing productivity grew by more than 100%, while the rest of the business sector’s productivity increased by less than 60%. Conclusion: we get far more out of our workforce today than we did in 1987 and than many businesses do today.

Between 1995 and 2008, manufacturing prices decreased by 3%, while the overall price level in the economy increased by 33%. Conclusion: while product quality has improved, and costs have fallen, prices have also declined.

The overall picture the manufacturing sector portrays, over the last twenty-five years, is that hostile market conditions produce better products and lower prices for customers, both at the same time.

Does the Withdrawal of Capacity Help?

2011-07-22T18:04:00.000-07:00

As industry prices fall, and companies’ fortunes decline with the resultant squeeze on their margins, some companies, especially the leaders, seek to withdraw capacity from the market. The leading companies expect the capacity withdrawal to do two things: redress the imbalance between capacity and demand; and raise prices to more attractive levels because of this better balance. In practice, the withdrawal of capacity often fails to achieve either of these objectives.

Whenever a leader in an industry reduces its capacity to force price increases, it must consider how competitors will respond. In many, if not most, cases low-cost competitors expand their capacity to make up for the withdrawal of capacity by the industry leaders. The end result often is even more capacity available in a marketplace and the same or lower prices available for the industry leaders.

After several quarters of improving profits, the airline industry is again slipping into hostile market conditions as rising fuel prices reduce margins and force higher prices. Higher prices limit demand growth. In response to the margin squeeze these tougher times bring to the industry, the industry leaders are restricting the growth in their capacity and, in some cases, reducing the capacity they offer in the domestic U.S. market. The problem is that several of the industry followers are not going along.

United Continental Holdings and AMR Corporation’s American Airlines have both posted losses for the most recent quarter. Both of these industry leaders plan to reduce their domestic capacity as a result. They will be reducing seats available flying into and out of selected domestic markets.

The pattern of leaders reducing capacity and followers adding it seems to be holding in the current airline industry. Southwest Airlines, JetBlue Airways and Alaska Air Group derive most of their revenues in the domestic U.S. market. Each of these companies reported profits in the most recent quarter. This profitability of the three follower airline competitors indicates that their costs are lower than are the costs of the two legacy airlines that have reported losses, United Continental and American Airlines. Southwest plans to increase its capacity by 5% to 6% in 2011. JetBlue plans to add 6% to 8% this year, while Alaska Air plans to grow its capacity by 9%.

The industry followers are able to add capacity in the face of capacity withdrawal by their larger industry-leading competitors because they have these lower costs. The lower costs enable the follower companies to make a profit while their larger competitors suffer losses. In the long run, the only way that the industry-leading competitors will be able to stop the expansion of these follower competitors will be to match or beat their lower cost structures

Failures in Reliability Lead to Share Loss

2011-07-06T16:04:00.000-07:00

We have written several times before about the Customer Buying Hierarchy (i.e. customers buy Function, Reliability, Convenience and Price, in that order). We have also written, on several occasions, about companies winning and failing customers in a marketplace. In a stable market, failure of a supplier causes more market share to move than does another competitor’s “win” of market share against its peers. Most failures occur in Reliability. Recently, two of America’s paragon companies have failed their customers on Reliability and are now struggling to catch up. Other leaders have had a similar problem and have recovered nicely.

Macy’s is a clear leader in the department store market. Over the last several years, Macy’s has purchased and integrated other large department store competitors. For example, in 2005 Macy’s purchased May Department Stores. As the company worked to integrate these acquisitions and obtain synergistic savings, their attention swerved from customer service. The company’s failings were greatest in customer interactions with the company’s sales associates. Nearly half of customer complaints focused on actions of sales associates. These are failures in Reliability. A customer expects to be well treated by a department store that charges relatively high prices for its goods. Macy’s failed to do that. The company’s market share began to drift lower as a result of these failures.

Now Macys is investing a great deal more money and time into the proper training of its sales associates. This investment is beginning to pay off. A recent survey of customer satisfaction indicated that the company was making strides in improving its reputation. Still, it lags the performance of some of its important rivals. This is still a Macy’s work-in-progress.

Wal-Mart is another industry paragon who drifted from its Reliability promises. Wal-Mart committed two notable sins. First, it removed some products that were important to its core customers. The company did so in an effort to improve the product mix and the margins a better product mix would bring. Some of its core customer volume began to drift away. The company also moved away from its aggressive pricing. Instead of every day low prices, the company began to promote deals on some products while raising prices on others. Customers didn’t like that either. Recently, a survey by a retail consulting firm has found that Target Stores offered prices below those of Wal-Mart. So, Wal-Mart has created Reliability failures in both product availability in its stores and its promise to have “always low prices, always.” The company’s market share has also drifted lower.

Wal-Mart now promises to return to its core values and core customers. It is bringing back the products it once eliminated in favor of higher margin products. It is getting more aggressive in pricing once more. This, too, is a work-in-progress.

Certainly, these leaders can recover from these miscues. We have seen other leading companies struggle with Reliability and yet recover nicely. For example, several years ago McDonald’s went through a period of time where it was losing market share. As the company examined the reasons for this market share loss, it noted that customers began to see its prices as high in the quick service restaurant industry. In addition, its products in stores had developed a reputation as being about the same as or, in some cases, lower in quality than some of its big competition. Under the leadership of a CEO well versed in operations, the company returned to its roots by emphasizing its core quality values and aggressive pricing. Today, McDonald’s is the unquestioned leader in the quick service restaurant industry. Many of its competitors struggle to keep up with McDonald’s. Most fail to do so. McDonald’s again has gained share in the industry over the last several years. McDonald’s success in reversing its Reliability failures suggests that the pathway is open for both Macy’s and Wal-Mart. They both should be able to enjoy similar success. The odds are they will.

The Mobile Phone Industry and Customer Retention

2011-06-29T17:14:00.000-07:00

The mobile phone industry’s growth has slowed. It is now operating more like a stable, moderate to slow growth market. This is particularly true in Europe. To face the challenge of slower growth in the industry, European mobile operators are turning to customer retention, but they are careful of the customers they seek to retain.

The Europeans have observed that less than 20% of an operator’s customers generate to 80% of the operator’s total revenue. This pattern repeats itself in many industries. When we have seen these patterns in other industries, we have also noted that less than 10% of the total customers generate an astounding 50% of total revenues. These are the really important customers in an industry.

A company must retain its key customers. In the mobile phone industry, as in most industries, the largest 20% of the industry’s customers are likely to be what we would call Core customers for the industry’s larger competitors. A Core customer allows supplier company to earn at least the cost of capital through a business cycle. The retention of these core customers is of paramount importance to long term company success. It costs a great deal more to find a new customer than to retain and build the relationship with a customer you already have. In the European mobile phone industry, carriers have found that it costs ten times more to acquire a customer than to retain one.

The industry has found another important phenomenon associated with customer defection. Recent research has told it that defection is a social phenomenon. If defecting customers leave an operator, they usually are not quiet about it. They tell their friends. In turn, some of their friends defect as well. So, the loss of a Core customer to an operator will often bring with it the loss of several other Core customers.

The mobile phone operators in Europe are working on retention by focusing particularly on those Core customers most likely to defect. These operators have analyzed the value of their customers and have assigned a rating to each customer. When a customer calls a call center, the information about the customer, including his rating, is readily displayed on the service representative’s screen. This customer specific information enables the service representative to respond with different value offers, depending on the importance of the customer. Most of these offers reflect lower prices for a potential defector.

But the industry is responding to potential defections with more than simple price reductions. Some companies are developing personal calling rates and plans tailored to individual Core customer habits. One European company instituted this individual approach and cut its percentage of customers defecting each year in half, from 20% to 10%.

The industry has found another important phenomenon associated with customer churn. Recent research has told it that defection is a social phenomenon. If defecting customers leave an operator, they usually are not quiet about it. They tell their friends. In turn, some of their friends defect as well. So, the loss of a core customer to an operator will often bring with it the loss of several other core customers.

Customer retention is an important, strategic management imperative, even in fast growing markets

A Likely End Game to Hostility

2011-06-22T15:06:00.000-07:00

The hard disk drive business has been a lousy place to compete for nearly twenty-five years. It has been the graveyard of many competitors. Twenty years ago, there were eighty disk drive manufacturers. By the mid-90s, there were only fifteen. By 2001, there were eight, and today it appears there are only four. But the fact that we are at four competitors, especially the size of the leading competitors, means that the industry is likely to come out of its recurring bouts of overcapacity and hostility.

As 2011 began, there were five hard disk drive manufacturers. Western Digital led the market with a 31% market share, followed closely by Seagate with a 29% market share. Hitachi enjoyed an 18% market share, while Samsung and Toshiba shared the remaining 22% of the market. Recently, Western Digital agreed to purchase Hitachi. This acquisition would bring Western Digital’s potential market share to 49%. The top two of the remaining four competitors would then have a potential market share of 78%. The top three would have more than 85% of the market.

Hitachi was not just any other competitor in the market. It had a well deserved reputation for being the most aggressive price discounter in the market. Hitachi was the major reason that pricing stayed under pressure in the hard disk market. Western Digital’s acquisition removed the major discounter.

In the past, acquisitions among the hard disk drive manufacturers brought somewhat better margins to the remaining players, but not as much market share as the acquisition would suggest. The reason was customers rotating other strong suppliers into their relationships to maintain low prices. With only four players left, and a dominant leader in the market, there is little purpose for the three followers to discount against Western Digital. A discounter might pick up some temporary share in a market saturated with “last look” arrangements, but it might face a very aggressive pricing response by one or both of the remaining leaders in the market. No, rather than discount, the economics for all the players would argue for firm industry pricing. That is the most likely outcome of this acquisition.

Over the years, we have studied many industries in overcapacity. Overcapacity produces a hostile market, where returns are low and price competition remains intense. These kinds of markets end in one of two ways, either demand picks up and sops up the industry’s overcapacity, or the industry consolidates to the point where the top four competitors control 85% or more of the industry’s volume. The remaining players then demur from competitive price discounts. The majority of industries see demand growth pull them out of hostile conditions.

There is one potential fly in this hard disk ointment. Computer tablets and other portable devices don’t use hard disk drives. Instead, they use NAND flash drives. These are solid state drives. They are more expensive than hard disks, have a much smaller form factor and are generally more reliable. Samsung, Toshiba and SanDisk are the leaders in this market. It could happen that Samsung and Toshiba, two of the four remaining hard disk drive suppliers, use low prices in the hard disk market to create customers for their more expensive flash drives. It is more likely, however, that these two companies, who are distant followers in the hard disk market, would prefer to see higher prices for hard disks. These higher prices on a competitive product would help some customers in the market transfer alliance to flash drives.

This acquisition should be a good deal for the remaining four hard disk players. While some analysts have argued that the hard disk drive market will slowly die under the pressure of the growth in the applications of flash drives, industry observers still see an 8% per annum unit growth for this market over the next five years. That unit growth should come with better margins for the remaining players.

Nestlé’s Cost Reduction in the Coffee Business

2011-06-01T19:47:00.000-07:00

Nestle is the world-wide leader in the coffee business. They offer coffees at virtually all price points. They invented instant coffee in the 1930s. After the buffets of the commodity markets over the last few years, the company has created a global push to reduce its costs and to increase the quantity and quality of the coffee it buys.

We have found four generic approaches to reducing costs.

• First, reduce the rate of cost of a cost input.

• Second, reduce the cost inputs that do not produce output.

• Third, reduce unique activities and components in processes and the product

• Fourth, spread fixed cost activities over additional product output

Nestle is using the first three of these approaches in its world-wide investment in cost management.

First, Nestle redesigned part of the process. Its scientists developed a new generation of Robusta and Arabica coffee plants for Mexico. The Robusta beans are relatively inexpensive and make up the bulk of the beans in instant coffee. The Arabica beans are more expensive, harder to grow and go to the higher end coffees. Today, Nestle has planted 100 thousand coffee trees in Mexico using its newly designed coffee trees. Once this experiment is complete, the company plans to distribute 220 million plants to coffee growers world-wide over the next ten years.

The use of these new plants will enable Nestle to reduce its rate of cost for the beans it buys. The new plant design increases yields so it eliminates some inputs that do not produce the output of coffee beans. Many long-term coffee farmers are using older trees, which yield fewer beans and lower quality beans. Many of these farmers are leaving the industry since they cannot compete. This magnifies the commodity price problem Nestle faces. Nestle’s new trees fit the region’s climate. They resist disease and allow for larger and easier harvests. These trees will make coffee beans more consistently and predictably available. Nestle will give these trees to the farmers without asking for a firm long-term contract or ownership of any part of the farm. But it should be obvious that Nestle will engender a great deal of farmer loyalty with this program.

Nestle also expects to reduce the rate of cost it pays for its beans with two other cost reduction initiatives. It will offer farming and investing advice to up to ten thousand farmers world-wide. As these farmers become more efficient, Nestle’s costs will drop. In addition, Nestle will also increase the amount of coffee it buys directly from the nearly 170 thousand growers who produce its coffees.

This kind of foresight and innovation suggests why Nestle commands its market leadership.

Cable T.V. and Customer Retention

2011-05-25T16:02:00.000-07:00

Recently, I decided to test the waters for a less expensive television experience. I have been a loyal cable subscriber for thirty-five years, but friends have told me that other systems, especially satellite, are cheaper. I went online to DirectTV.com to check their packages. We have been spending about $112 a month. The equivalent package from DirectTV appeared to be about $81 a month. I was shocked at the size of the price difference. DirectTV was more than 25% less expensive than Comcast, my cable supplier.

Given the size of these price differences, I did some investigation in what is happening in the market. Today there are four potential television service suppliers: cable, telephone companies, such as AT&T and Verizon, satellite and internet companies, such as Netflix and Hulu. The cable companies command 60% of the market. Phone companies have less than 15% of the market. The satellite firms, including DirectTV and Dish, control most of the rest. The internet firms are still small, though they may become larger in the future. Over the years, the cable companies have held a high price umbrella over the satellite companies. Now the phone companies are getting under this umbrella as well. The cable companies lost two million subscribers last year. The phone companies picked up most of that loss, while the satellite firms picked up a bit. The combination of the phone and satellite companies took virtually all the growth there was in the market.

Customer retention is a big deal. Even in fast-growing markets, you would like to be able to retain your customers when competitors seek them out. The cable companies have sought to retain customers by emphasizing more services to higher spending customers. These customers tend to be less price-sensitive. It appears that the cable companies are going to have to alter their courses. They simply can not afford to let their competitors take away their market share. Eventually, the competition will be as big and as strong as they are. They will lose the market leverage that a leader enjoys. For examples see GM in autos, IBM in the PC market and U.S. Steel in the steel market.

The T.V. market is speaking in clear tones. The phone and satellite companies offer a better value proposition. The cable companies have to listen soon.

The Kindle with Special Offers…not your typical low-end product

2011-05-16T15:26:00.000-07:00

Amazon has introduced a low-end Kindle product, the Kindle with special offers. This Kindle sells for $114 compared to the standard $139 Kindle with Wi-Fi. This is not a typical low-end product. Low-end products offer fewer benefits than industry-leading products (we call these Standard Leader products) for either the buyer or the user of the product in return for a lower price. We call these low-end products Price Leaders. There are two kinds of Price Leaders. The first, called Strippers, strip out benefits for both the user and the buyer of the product in order to achieve a very low price. The second, Predators, offers the user equivalent benefits to the industry’s main product but fewer benefits for the buyer. On average, Price Leaders cost about 33% less than Standard Leader products.

You will note that the Kindle with special offers does not fit easily into either of these two Price Leader categories. It reduces the user benefits by delaying the use of the product until the customer has viewed advertisements. There is no change to the benefits offered the buyer of the product. The Kindle with special offers deviates from the norms of Price Leader products with its level of discount. The Kindle with special offers sells for about 18% less than the standard Kindle product.

The Kindle with special offers varies from the Price Leader pricing norm in another interesting and important dimension. Some of these “special offers” are really good deals for the average Amazon customer. In one particularly interesting offer, Amazon will sell an Amazon Gift Card worth $20 for just $10. So, an avid fan of the Amazon web site receives additional user benefits with this new low-end product. In many cases, these special offers may more than offset the disadvantage to the user of a delay in using the product while the user views an ad.

This new Kindle with special offers is a very creative product innovation. Congratulations to Amazon.

Cable T.V. and Customer Retention

2011-05-04T11:46:00.000-07:00

A Squeeze at the Top

2011-04-26T16:12:00.000-07:00

The very highest end of Parisian hotels includes such names as the Crillon, the Plaza Athenee and Le Bristol. There are four of these highest prestige hotels in Paris. Their prices start at Euro 750 a night. Average room prices run around Euro 1000 a night. These are among the highest prices for hotel rooms in the world. Still, occupancy rates run around 80%. Even in the doldrums of 2008 and 2009, they fell only to 70%.

Something new is happening, though. The high end of the market is about to see a doubling in capacity as four new luxury hotels open over a three year period. Two are already open and two more will open over the next two years. There is a prospect for even more coming beyond this next two year window, as other competitors mull a market entry.

Many experts believe that prices will hold steady despite the massive influx of new capacity. They cite an increase in demand to support their beliefs. This demand is to come from Chinese tourists upgrading from luxury boutique hotels and from the growth of major conference events.

Really, though, it isn’t the price that is at issue with this new capacity. It is margins. This new capacity, despite being at the very high end of the market, is coming faster than demand is growing. As a result, margins, if not prices, will fall. This margin squeeze has already started. The existing high-end hotels are spending money to upgrade their current offerings with celebrity-chef restaurants, branded spas and upgraded hotel rooms. Even if prices stay the same as they are today, margins will fall until demand fully catches up to this new capacity.

While it is always margins that suffer when the growth of capacity outstrips the growth of demand, I would not want to bet on prices holding as steady as these analysts expect. My guess is that industrial conferences who can afford to place their attendees at the highest end hotels will also be able to negotiate room price discounts over the next couple of years.

Another Creative Pricing Scheme

2011-04-20T16:29:00.000-07:00

It is not often that you see companies using really unusual pricing to build future business. Here is one that I like.

Every price has three and, usually four, components: the Benefit Package, the Basis of Charge, the List price and usually some Optional Components of price. The Benefit Package includes all of the Function, Reliability and Convenience benefits associated with the main product. The Basis of Charge is the way the company quantifies the unit of sale that it prices with the List Price, which is the stated price per unit of product sold. The Optional Components of price enable the company to leave the List Price unchanged, but to alter the value the company offers the customer by changing Functions, Reliability or Convenience benefits beyond those of the main product. The most creative pricing schemes usually involve the Optional Components of price.

Recently, we described one of these Optional Components of price, a Call, offered by Continental Airlines. In this blog, we will describe a “Put” offered by Best Buy. A Put is an Optional Component of price that enables the customer to sell back a product to the seller at a stated price in the future.

Best Buy recently introduced the Buy-Back program for various electronic gadgets it sells. This program adds a fee to the original List price of the product. In return for that fee, the customer gets the right to bring the product back for up to two years for a return value of a stated percentage of the original List price of the product. These percentages run from 20% to 50%, depending on the time of the return. The value of the return itself comes in the form of a Best Buy gift card. Best Buy hopes the customer will use this gift card to purchase an upgrade on the product that the consumer returns.

This Put may be attractive to consumers concerned about the speed of technological innovation in electronic gadgets. The Put effectively reduces the future price of purchasing a new electronic gadget. It leaves the current List prices and future List prices unchanged. It also increases the odds that Best Buy will be the retailer who delivers the new technologically-advanced product.

The NYSE Stumble Offers a Lesson for All Leaders

2011-04-06T17:00:00.000-07:00

Recently, the New York Stock Exchange agreed to sell itself to the German exchange, Deutsche Boerse. For generations, the NYSE was the place to trade equities of the finest companies in the U.S. Its sale to a German exchange is a sign of how desperate its market situation has become. The NYSE’s fall offers some important lessons for a market leader in any industry.

The NYSE’s market share has fallen out of bed. Six years ago, 75% of the traded shares of companies listed on the New York Stock Exchange traded on that exchange. Today, only 35% of those shares trade on the NYSE. This precipitous fall came because the NYSE fell behind in both service and price. The market changed and new competitors emerged.

First, the market changed. High frequency traders, using computerized trading algorithms, do two-thirds of share trades today. These market-dominating customers demand the highest speeds in their transactions and the industry’s lowest prices. The New York Stock Exchange struggled to meet these requirements.

Second, new competition emerged. There are roughly fifty trading venues which will provide these high-frequency traders with fast services and low prices. The majority of these venues did not even exist ten years ago. They sprang up using relatively inexpensive computers in low-cost outlying and suburban locations. These new trading venues offer newer, faster technology and lower prices than the NYSE.

The NYSE held a price umbrella over these emerging firms. The new firms grew and became ever more capable. Today, they can compete and win in competition for even small trades.

The New York Stock Exchange was a dominant market leader. Its precipitous fall holds lessons for all market leaders in any market. Among these lessons are these:

1. Always protect your relationships with the industry’s heart-of-the-market customers. These are the key, primary and secondary relationships with the industry’s large customers, those purchasing 80% of the industry’s unit volume. These key relationships usually hold 65% or so of the total industry sales.

2. Avoid consistent failure with these heart-of-the-market relationships, especially failures in function and price. Customers generally will not leave an established relationship until their supplier fails them. Any failure, especially consistent failure over time, opens the customer relationship to other competitors.

3. Parry fast-growing competitors at any price point. The fast growth of these competitors tells us that customers like what they offer. Their growth in share will not stop until the market leader itself puts an end to it. The NYSE has allowed many new competitors into its marketplace. It would have been much easier to stop them when they were much smaller or, indeed, even before they entered the market. This market will consolidate again into far fewer competitors. But now it is going to be a bloody fight.

4. Fix the products that are losing share in the heart-of-the-market. Customer retention is important in any market, but it is critical in markets where prices are falling. The first demand of product innovation is to fix problems that cause the company to lose customer relationships.

5. Cover any price point your heart-of-the-market customer purchases. Companies often have price point biases, either against a low price point because it pulls down margins, or against a high price point because it makes operations less efficient. If the heart-of-the-market customers are buying the price point, you have to cover it.

6. In a falling price environment, develop pricing that discourages competition. This pricing can, and should, involve more than simple reductions in list prices. There are several components of a price. The NYSE can use these components to beat back many of these competitors. In a low, or falling, price environment, the only real function that price serves is to discourage competitors from competing for your customers. Ultimately, low prices push competitors out of the marketplace. This takes a long period of time when there are as many competitors as the NYSE faces today.

7. Develop and exploit economies of scale to support the falling prices the company faces and to maintain the best returns in the industry. The NYSE is still the largest competitor in the market. It no longer enjoys dominant share, but it is still large enough to create a more productive cost structure, especially by matching benefits and overhead costs to customer segments and eliminating benefits that customers do not need.

Amazon's Blockbuster Innovation

2011-03-30T12:25:00.000-07:00

In 2005, Amazon introduced its Prime Free Shipping program. This yearly subscription program promised free two-day shipping on any purchase the subscriber made from Amazon. Five years later, 13% of Amazon’s 130 million active users are Prime members. More significantly, 20% of the subscribers who purchased products from Amazon in the last twelve months are Prime subscribers. These Prime subscribers purchase two to three times as much as non-Prime subscribers over the course of a year. This Performance innovation removes an impediment to purchasing on Amazon. In fact, it increases the odds greatly that online purchases will be made on Amazon rather than on a competitive site. This has been a blockbuster innovation for Amazon. The innovation holds a special appeal to the larger customers in the market. The Prime subscribers may also offer Amazon an entry into a business that it has longed to gain, for several years, subscription video rentals. It appears that Amazon will introduce a streaming video product for its Prime subscribers. This new product will not cost the Prime subscribers any more than their normal subscription. Netflix’s Watch Instantly service cost about $96 a year so Amazon may have a price advantage on Netflix. Of course, Convenience and Price are only important provided Amazon offers equivalent Function, that is, streaming video content. We don’t know about that yet. Still, Amazon has proven to be an innovative company who can find ways to build a business in non-traditional ways. It continues to grab market share in the retail business.

Whirlpool and Electrolux Blink

2011-03-23T14:16:00.000-07:00

The home appliance market has been a difficult place to compete during several periods over the last thirty years. It is tough again today. Sales of large appliances have fallen steadily since 2007. Competition is intensifying with the pressure of the South Korean competitors, LG Electronics and Samsung Electronics, on Whirlpool Corp and Electrolux AB. Whirlpool and Electrolux are suffering from rising costs for steel, copper, plastics and other raw materials. To offset these cost increases, the two companies plan price increases of 8% to 10% in the spring.

The problem: the Koreans aren’t playing ball. The two South Korean firms are pricing aggressively and have been doing so since Thanksgiving 2010.

The South Koreans are formidable competitors. At one time, LG was known as Lucky Goldstar, a seller of low-end, cheaply made, products. Today, it has a much better brand name and sells quality products. Samsung does as well. It is a leader in the large screen TV market. The products that the South Korean companies are pricing aggressively are not the low-end products. They are the mainstream, heart-of-the-market, products.

The domestic U.S. market is slow growing. So is the market in the rest of the world. The North American market is growing 2% to 3% a year. Europe is growing 2% to 4%, while Latin American and Asia grow in the 5% to 10% range. Large appliance companies will have no trouble supplying all the capacity the market needs at these demand growth rates. The industry is likely to have excess capacity for the foreseeable future.

If the two Western competitors institute their price increases without the two South Korean companies in a lock-step march, they will be in a Leader’s Trap. A Leader’s Trap occurs when one or more of the leading companies in an industry hold its prices high in the mistaken belief that customers will stay loyal despite the lower prices of competition. Leader’s Traps rarely end well. Either the Western competitors will lose market share or they will ultimately rescind their price premiums.

These four giant large appliance competitors are peers of one another. The only way to stop the Koreans from discounting against the Western competitors is to have a cost structure that scares them out of the discounts. The discounting competitors have to see that their discounts will only cost them margins because the other peer competitors in the market will match their low prices since they have equally low cost structures.

News Corp Responds to the Market for “Free”

2011-03-14T16:15:00.000-07:00

The newspaper industry has faced a mighty challenge over the last few years. There is so much “free” content to complete with them. Newspaper revenue continues to plummet. Internet users are reluctant to pay for content. All the free content, supported by advertising revenue, has decimated the newspaper industry. The industry’s cousin, the magazine industry, is not far behind.

This trend can’t continue forever. Already, many people are asking themselves how much they can trust the information on the internet. The need for Reliability drives the demand for Snopes.com. How many “free” web sites can earn enough from advertising to pay all their bills? An effective industry answer to “free” may be forthcoming in the News Corp online newspaper called “The Daily.” The Daily will cover general news, sports, arts and opinion in a format dedicated to the Apple iPad. In addition to the written content, the product will carry high definition video and 360 degree photos. The same product will be available in a few months for the Android-based tablet computers.

The Daily will sell for $.99 a week, or $39.99 a year, a very low price compared to newspapers. With this model, the product receives revenues both from the subscribers and from advertisers. Subscribers have the Reliability benefit of knowing that the content producer cares about facts, accuracy and readable writing style. Advertisers pay for eyeballs that follow a Reliable product.

The Daily is what we call a Next Leader product. This is a product that offers much better than industry standard performance for a low price to a specific subset of industry customers. The Next Leader can offer the very low price because it has a much lower cost structure than is typical in the industry. There are two basic types of Next Leaders. The first are Reformer products. This type of Next Leader product reduces the benefits for the user (usually Function benefits) while increasing the benefits for the buyer (usually Reliability and Convenience benefits) compared to the industry Standard Leader product. The second of the two types of Next Leader products are Transformer products. These products increase the benefits of the user but offer, at least initially, fewer benefits to the buyer than the Standard Leader product offers. The Daily is a Reformer product. It offers the Convenience of formatting fit for a tablet computer so it provides easier access for a segment of the industry’s customers. Its low cost structure results from its elimination of printing presses and distribution costs.

If this new tablet-based product offers a quality read, it will hasten the day when virtually every newspaper and magazine is offered first online and only secondarily in hard copy. The online versions will come at a fraction of the cost of the hard copy versions. Readership is certain to grow.

The Long and Arduous Journey of the Airline Industry May be Reaching an End

2011-03-10T14:50:00.000-08:00

The government deregulated the airline industry in 1978. Since that time, the basic pricing in the industry, as well as airline fortunes, have been more or less continuously on the downward slope. It has been a very long trip down.

The industry may be heading up again, though. In the third quarter of 2010, the average domestic airfare was 11% higher than a year earlier. Profits returned to the industry in 2010 behind higher prices. In some part, these higher prices were the result of the additional fees that most of the domestic carriers charged passengers for checked baggage, better seating, rerouting and so forth. Still, the industry was able to hold its higher prices.

These prices are holding because the major industry players are less enamored of discounted flying. All of the big airlines are finding ways to extract prices from industry customers. Now that airline capacity utilization is high, the industry is more careful about capacity additions. Higher prices are here to stay.

The consumer still is far ahead. Even at these higher prices, ticket prices are a bargain. In fact, ticket prices, adjusted for inflation, are 20% below the levels of 1995. The industry has continuously stripped benefits from the base product in order to save costs. In 2010, the industry added back a few of those benefits (for example, economy plus seating) for an additional charge. We may see more of that over the next few years.

The Advent of the F-commerce Evolution

2011-03-07T13:21:00.000-08:00

Don’t look now, but we are entering the world of F-commerce. What is that, those of you older than thirty will ask? F-commerce is selling through a Facebook page.

The trend is early yet, but likely to turn into a stampede. JC Penney and 1-800-Flowers.com both have established full E-commerce stores within their Facebook page. The stores include check-out and other features you typically find on an E-commerce web site. Facebook claims that twenty-five of the largest retail sites are already integrated with Facebook, as are seventeen of the twenty-five fastest growing retail sites.

Think of Facebook as a virtual mall. There are all kinds of people wandering around there, talking to one another. Facebook offers a nice opportunity for a company to interact with customers and allow them to bring their friends into the conversation to evaluate styles and colors and so forth. If a company integrates its storefront with the Facebook page, its Facebook “friends” will never have to leave the virtual mall in order to purchase. This is an important product innovation.

Product innovations reduce customers’ effective costs in one of three ways: add information about the product and how it is to be used, reduce the resources the customer must use with the product, or improve the customer’s experience with the product.

This innovation improves the customer’s experience with the product by increasing the customer’s sense of security in using the product. It allows the customer to get her friends’ opinions on what she is purchasing. Secondarily, the Facebook store reduces the customer’s resources used with the product by reducing the time the customer must spend in using the product. The innovation reduces the steps the customer must take to make a purchase and it places the company’s product closer to the customer’s location.

This is going to be a train to the destination of millions of customers. Every mainstream retailer has to get on board.

Cost Reduction by Redesigning the Product

2011-03-03T15:53:00.000-08:00

Over the last several years, we have studied many examples of cost reduction initiatives to improve productivity and create economies of scale. In simplest terms, there are four actions that improve productivity and economies of scale. First, reduce the rate of cost you pay for an input. Second, reduce the inputs that do not produce output. Third, reduce unique activities or components in products and processes by redesigning the products and processes. Fourth, spread fixed cost activities over new product output. The cellular telephone carriers are introducing measures to reduce their costs by redesigning the product.

The wireless carriers use cellular towers to broadcast their signals. The cellular product design offers signals traveling long distances, primarily for voice and for relatively low data speeds. A cellular tower is expensive but capable of sending a signal for several miles.

This cellular technology worked well until the evolution of the smart phone. The growth of the smart phone has put very high demands on the cellular tower infrastructure because of the heavy data usage it brings to the market. Since 2010, data has taken over the majority of network traffic from voice communications. Now the carriers and, in particular, AT&T with its Apple iPhones, is having difficulty keeping up with the growth in demand.

AT&T today and, likely a few others in the future, has found a potential innovative solution, adding Wi Fi access points. These Wi Fi access points are ideal for heavy data traffic sent at high speeds over relatively short distances. Wi Fi access points transmit signals over a few hundred feet. The Wi Fi access points are smaller, easier and cheaper to install than are cellular towers. This low-cost approach appears to make sense in areas with high density of users. AT&T has placed them in New York’s Time Square and Rockefeller Center, in downtown Charlotte, North Carolina, in neighborhoods surrounding Chicago’s Wrigley Field and in San Francisco’s Embarcadero Center.

But there are some drawbacks to Wi Fi access points. Sometimes, a user has to take several steps to connect to a Wi Fi access point. Signals from the Wi Fi access points may interfere with one another, if signals come from multiple networks. Some smart phones do not have Wi Fi capability. These disadvantages have, so far, held back Verizon Wireless’s adoption of this apparently low-cost approach to providing service.

AT&T is leading this cost-saving innovation experiment. Their network strains force it to be creative and experimental. AT&T saves costs by redesigning the product itself using a less expensive technology with some shortcomings. If the AT&T experiment proves both cost effective and acceptable to cellular customers, every other wireless carrier will be forced to adopt it. And since a Wi Fi access point is largely a fixed cost, the wireless carriers with the highest density of membership within the Wi Fi area will have the lowest cost per unit. In most areas of the country that is likely to be either Verizon or AT&T. They will end up getting a unit cost advantage over their smaller competitors…if this works.

The Japanese Pay the Price

2011-02-28T16:34:00.000-08:00

The figures are in for U.S. auto sales in 2010. The biggest winners in percentage growth were Hyundai, at 24%, and Ford at 20%. Toyota lost .4% and Honda grew a mediocre 7%. The Japanese struggled in 2010.

Earlier we wrote a blog about Ford’s ascendency and Toyota’s problems (see Blog HERE). Toyota is paying the price for failing its customers. Honda appears to be getting painted with the “failure” brush, though I doubt its punishment is deserved.

I am actually using the word “fail” to mean something specific here. A company fails its customers when it is unable or unwilling to do something that at least half of its competitors can, or will, do for customers. Toyota’s troubles with accelerators, floor mats, and so forth, received extensive media coverage. This coverage clearly has had a negative impact on Toyota this year.

Toyota’s struggles illustrate the win and fail dynamic. In our terms, a “win” occurs when a company is able to do something that the majority of its competitors either can not or will not do. Wins account for a good deal of market share growth in a fast-growing market, but are less important in more mature markets. In a more mature Stable market and, especially, in all Hostile markets, failure moves a significant amount of market share.

Here is what this means. The decision to change a supplier is really two decisions. The first is the decision to leave a current supplier and the second is the decision on which new supplier to take on in your relationship. In the average Stable and Hostile marketplace, more market share moves on failure than on wins. This means that before an established customer will change suppliers, its current incumbent supplier must “fail” the relationship in some way. This failure, then, opens up the customer’s relationship to competition among other potential suppliers. Whichever supplier gains this customer’s volume really did so only after the incumbent failed. We call this gain a “weak win.” The “weak win” would not have happened on a straight-up comparison of performance and price of the new supplier versus the old. The gain only happened after the incumbent clearly failed the customer and then opened the relationship to someone new.

Toyota’s failure was largely a failure of Reliability. It clearly lost share. The companies that gained this share from Toyota, Ford and Hyundai among them, enjoyed some degree of a “weak win” in the domestic automobile market. They may have “won” market share as well, but my guess is that most of their share gains from Toyota fell to them from Toyota’s “failure.”

But Can You Control Other Entrants?

2011-02-23T12:01:00.000-08:00

The United Autoworkers (UAW) is on a new campaign. The union plans to organize workers in hither-to non-union foreign-owned automobile plants in the United States. This campaign may or may not work, but in the long run it will prove futile unless the union can compete in the international market, against all international auto workers.

There are 575,000 autoworkers in the U.S. Nearly 20% work for foreign-owned plants. All of these plants are non-union. The foreign-owned plants were intentionally placed in right-to-work areas, many in the South.

The UAW is likely to have some difficulty succeeding with this campaign. The non-union workers already earn highly competitive wages and benefits. To date, these U.S. workers in plants owned by Toyota, Volkswagen, Hyundai and Honda have shown little interest in unionization.

Why would the union be so interested in this initiative? To preserve its membership. The traditional problem with unions is less the rate of wages they demand and more about the work rules they impose. These work rules reduce the productivity of the unionized plants. That has certainly been the case in the U.S. auto industry. As a result, the UAW is losing membership as UAW auto plants in the U.S. close under the onerous costs the UAW plants carry. If the union can succeed in unionizing the domestic foreign-owned auto plants to the same extent they have unionized the domestic manufacturers’ plants, they will be able to impose the same work rules and produce roughly the same productivity. The result should, in the union’s eyes, be a reduction in the rate of jobs lost in the union.

But there is a problem here. The UAW has already seen that it was unable to stop new non-union plants in the U.S. How will it stop future non-union domestic plants? O.K., let’s say they can do that. Will they also be able to stop all foreign non-union plants from becoming established and growing? Certainly not. Unless the union membership can compete on an international basis with competitive costs and productivity, this unionization effort is wasted money. If it succeeds, the U.S. loses more plants to plants located offshore. Union membership still falls.

It seems that one of the problems for unionized employees is one of definition. Union members often call their compatriots in competing companies “brothers and sisters.” These are certainly not brothers and sisters. In a marketplace they are competitors. Union employees have to be able to beat, or at least stalemate, these competitors or lose their jobs. This is true as long as the UAW can not control the entrance of other less expensive competitors, either in the U.S. or elsewhere.

The long history of the DRAM semiconductor market illustrates this. The U.S. manufacturers of DRAM semiconductors faced intense competition from the Japanese in the 1980s. The domestic industry succeeded in slowing the Japanese by using the International Trade Commission. Then arose new and equally troublesome problems. These problems were DRAM semiconductor facilities in Taiwan and Korea. Eventually, the U.S. industry evolved to the point where it had only one domestic producer of DRAM chips. Intel was one of the early competitors to get out of that market to focus its resources in the more complex, and much more profitable, domestic micro-processor business. SX4MBURBCAJQ

Apple Gets Crossways with App Developers

2011-02-17T14:52:00.000-08:00

Recently, Apple rejected a digital book application from Sony. The disagreement here is over how and when Apple collects for its services. Apple is playing a dangerous game.

In theory, Apple has the right to insist, under its terms for developers, that any app, which offers customers the ability to purchase books outside of the app, offer the ability for customers to purchase within the app at the same time.

Here is the rub. In its application, Sony sends customers to its own web site where they complete the purchase of a book. By routing the customers to its own web site, Sony is able to avoid a payment of 30% of revenues to Apple.

Others, including Amazon, with its Kindle, and Barnes & Noble, with its Nook, have been able to sell e-books by sending users to the companys’ own web sites. Apple simply was not enforcing its policy requiring developers to use its in-app purchasing feature to buy new content.

A 30% charge on revenues is a high price to pay Apple. Apple may be setting itself up for future loss of market share by enforcing this policy. If the Android platform does not put the same requirement on its app developers, the developers will have a strong incentive to avoid the 30% charge by encouraging customers to purchase using an Android device rather than an Apple device. Alternatively, the application developers may charge a higher price for purchases through Apple.

Apple’s unique strength has been its superior list of available applications. Apple’s enforcement of this requirement to purchase inside the app so that Apple can collect 30% of the revenues puts at risk its major advantage. Apple needs to compromise here by charging a lower price or no price at all. After all, it already makes high profits on its hardware and software product combination. It also makes profits on many of the downloaded apps. The application developers are customers too. Why make their life difficult? Does the benefit Apple provides a seller justify 30% of revenues? Sounds pretty rich.

Constrictions in Components Supply Support Higher Prices

2011-02-14T13:54:00.000-08:00

Years ago we were doing some work in the roofing business. In one study, we were working on the asphalt shingle roofing manufacturing business. At the time, this was a terrible business. Returns were low, growth rates were modest, at best, and there was a good deal of overcapacity in the industry. Then the industry caught a break. A shortage in asphalt developed. This shortage of asphalt rolled through the asphalt shingle plants and restricted their output. Immediately, prices jumped, returns became attractive and industry participants breathed a sigh of relief. Unfortunately, this asphalt shortage did not last very long. The industry shortly returned to its previous hostile condition. (See the Perspective, “What Ends Hostility?” on StrategyStreet.com.)

A shortage in any component, or labor, will restrict industry capacity and tend to raise prices. A labor shortage is, in part, responsible for some of the high prices in mining today. Miners work in areas that are often hard to reach. They also are skilled employees. The run-up in commodity prices, especially those related to ores such as silver, gold and copper, has increased the demand for these skilled miners. In addition, the mining industry faces competition for skilled workers from the oil and natural gas industries, which are also growing.

Mining companies are now going to great lengths to attract and retain these skilled workers. Some of these miners are now earning 25% more in compensation than they were a year ago. Some companies are flying workers to and from remote mines. For example, BHP Billiton plans to fly 500 workers from Brisbane, about 500 miles away, to a coal mine site that they are opening and then fly them back home after a couple of weeks.

If this commodity boom continues, the industry’s total capacity will be determined more by labor availability than by its more traditional measures of capacity. (See “Audio Tip #117: Capacity Constraints and Pricing” on StrategyStreet.com.)

Direct Edge: A Transformer Next Leader Product

2011-02-10T14:29:00.000-08:00

A Next Leader competitor is in an extremely fortunate position. A Next Leader is a competitor or product that offers much better than industry standard performance for a low price to a specific subset of industry customers. While offering better benefits to some customers, it may reduce benefits for others. But all Next Leaders offer low prices. The Next Leader can do this because it has a very low cost structure. (See “Video #22: Definition of Next Leaders” on StrategyStreet.com.) Next Leaders do not appear in many industries. When they do appear, they can change an industry, whether the industry is in manufacturing, retail or service. For example, Toys R Us invented the Toy Retailing Category Killer, a Next Leader product. Home Depot has done much the same in hardware retailing. Other Next Leaders include the early Apple personal computer, Intuit personal financial management software, Jiffy Lube in auto services and Domino’s Pizza.

We have studied many Next Leader competitors. Our study has suggested there are two kinds of Next Leaders products: Reformers and Transformers. A Reformer product is a type of Next Leader that reduces the benefits for the user while increasing benefits for the buyer, compared to the industry’s Standard Leader product. Jiffy Lube and Domino’s Pizza would both be Reformer Next Leader competitors. The second type of Next Leader competitor, Transformer products and companies, increase the benefits for the user of the product but offers, at least initially, fewer buyer benefits than the Standard Leader product. Toys R Us and Home Depot are two examples of Transformer Next Leader competitors.

Direct Edge is an example of a Transformer competitor. It offers its customers very fast securities trading on virtually any platform, from computers to smart phones. It is a young electronic stock exchange and it is having a big impact on securities trading. Its first noticeable impact is in market share. As recently as five years ago, the New York Stock Exchange accounted for 70% or more of the trading in the stocks listed on its exchange. Today, the stock exchange handles 36% of those trades. (See “Audio Tip #85: Evaluate the Company's Success in Penetrating each Price Point in the Market” on StrategyStreet.com.) Twelve other public exchanges, several electronic trading platforms and many “dark pools” command the rest of the market share in NYSE listed stocks.

Direct Edge came into existence during 2010. Several brokerage firms and other financial players formed Direct Edge to offer a counter veiling power to the New York Stock Exchange and Nasdaq. Direct Edge now owns 10% of stock trading in the United States.

Direct Edge is not only big and fast-growing, but inexpensive as well. It has ready access to the share trading of its brokerage house and hedge fund owners. It operates many banks of state-of-the-art computers in warehouse-type facilities in New Jersey rather than in more-expensive New York. And, despite its size, it has fewer than one hundred employees.

The evolution of these non-traditional exchanges has resulted in declining trading costs and much faster trading times for all customers. Next Leaders do that.

The iPhone Versus the iPhone

2011-02-07T14:31:00.000-08:00

After nearly four years, AT&T has lost its exclusivity on Apple’s iPhone. It has been a great run. Now AT&T faces the formidable competition of Verizon, who started offering the iPhone in February of 2011. Market shares are about to shift. Let’s look at how they might change.

Market shares among established customers shift for one of two reasons. (See Audio Tip #40: The Components of Market Share Change" on StrategyStreet.com.) First, a competitor may “win” market share by offering a benefit that more than half of the market suppliers do not offer. On the other hand, market share may shift away from a competitor if it “fails” its customer relationship and opens that relationship to other competitors. A company “fails” a customer relationship when it refuses, or is unable, to offer something that half the other competitors in the market can or will offer.

AT&T garnered much of its share gain over the last four years with a “win.” That “win” was due to its exclusive offering of the Apple iPhone. While it won business with the iPhone, it developed a reputation for problems in the quality of its services. iPhone users tended to overwhelm the AT&T network and cause interruptions and dropped phone calls. AT&T’s customer service has been suspect as well. Still, its market share has grown with the iPhone, primarily at the expense of the smaller carriers. Its market share growth due to the exclusive on the iPhone offset its “failures” in its network and customer service.

Now Verizon enters with its own version of the iPhone. Today, any customer who wants an iPhone can choose either the largest competitor in the market, Verizon, or the second largest competitor, AT&T as his or her carrier. So, Verizon can “win” market share against the smaller competitors as well. These competitors, such as Sprint, Virgin Mobile and others like them, do not offer the iPhone and are unlikely to do so soon.

Verizon should also be able to gain share at the expense of AT&T. Here’s how. iPhone-using customers who are dissatisfied with their current service with AT&T now have a viable, high quality competitor offering an equivalent service with the same phone. Some of these customers will leave AT&T because they perceive that AT&T’s services are not up to the standard of the other competitors, especially Verizon’s, and migrate to Verizon. This is a phenomenon we call “flight to quality.” This “flight to quality” is also an example of a “weak win,” where a competitor gains share only after an incumbent supplier has “failed” the customer relationship.

This “flight to quality” is unlikely to be dramatic. A company can “win” share quickly with a unique Function. On the other hand, a “flight to quality” usually brings share gains in dribs and drabs. It produces share gains slowly, over time, because of inertia in the customer relationships. This inertia allows AT&T time to get its house in order before it suffers a great deal of customer immigration. (See Video #36: Probable Priorities for Innovation in Hostile Markets on StrategyStreet.com.)

The Price Can Go to Zero

2011-02-03T10:09:00.000-08:00

For many years, the fees charged by investment managers of mutual funds grew ever so slightly, gradually approaching 1.5%. Over the last few years, though, the growth in these management fees has stopped. In fact, it reversed. Last year the average management fee charged for actively managed mutual funds was 1.38%, or 138 basis points, where a basis point is one tenth of one percent. But that average is badly misleading. It’s misleading because it treats all funds, regardless of size, as the same. When you adjust the fees for the size of the funds, you find that the dollar-weighted average for actively managed funds is now below 100 basis points. Three things have caused this reversal in management fees: low returns in the stock market, the growth of exchange-traded funds (ETFs) and a price war among the biggest players in the market.

The first two of these factors need little explanation. Over the last ten years, an investment in many bond funds out-performed an investment in diversified equity funds. These low returns have many investors focusing on the costs they incur for the management of their money. These costs include transaction fees for trading securities and management fees for the companies managing mutual funds or exchanged-traded funds. The second factor, the growth of ETFs, is somewhat less obvious, but important. ETFs have garnered a significant share of new money invested in equity funds over the last few years. Companies managing ETFs charge low fees for managing these funds because they have very low costs for shareholder servicing and some other administrative functions associated with investment management. Shrewd mutual fund managers have reduced prices in order to manage the gap in pricing they allow for their managed mutual funds compared to comparable ETFs.

These two causes of the fall in prices for investment management now have a third important factor. This third factor may turn out to be the most important of all. (See the Symptom & Implication, “The industry is seeing its first price wars” on StrategyStreet.com.) As described in other blogs (see blogs HERE and HERE), Vanguard has started, and continued, a price war in the ETF market. For example, iShare’s MSCI Emerging Market’s ETF and Vanguard’s Emerging Market’s ETF compete directly. Vanguard’s fund charges 27 basis points. The iShare’s fund charges 69 basis points. The iShare’s fund entered the market well before the Vanguard fund, and was much larger than the Vanguard fund. However, during 2010, the Vanguard ETF added $18 billion to its fund while iShare’s added about $4 billion. Price matters among peers.

The iShare’s funds are not always market share losers, however. The iShare’s Gold Trust is an ETF that competes with a larger rival, SPDR Gold Trust. Until June of last year, both of these ETFs charged 40 basis points. In June, iShares cut its management fees to 25 basis points. SPDR Gold Trust stayed pat at 40 basis points. Over the next few months, the iShare’s fund gained $875 million in new money, while the SPDR Gold Trust saw a net loss of $1.2 billion of money under management. Price matters among peers.

These management fees can even go to zero. One ETF today has no management fee, zero. It gets its revenues by lending out the securities in its portfolio. (See the Symptom & Implication, “Technology improvements bring falling prices” on StrategyStreet.com.)

Of course, as companies engage in price wars, they advertise their lower prices extensively in order to capture as much market share as possible before their competitors respond. The result: customers are becoming ever more price sensitive about the management fees they pay, simply because the management companies tell them to be more sensitive.

How long will it be until this fee warfare spreads to other smaller types of ETFs? Not very long, as long as price moves share.

Evolution of the Smart Phone Market

2011-01-27T14:08:00.000-08:00

The smart phone market is growing at a very fast pace. The number of smart phones sold world-wide is expected to grow at a pace of more than 15% a year. This is what we call a Developing market. The smart phone market portrays some interesting developments you might expect to see in other fast-growing markets.

Apple really made the market take flight with its original iPhone. Apple has migrated into the high-end, Performance Leader, part of the market with its iPhone4, selling for $199 with a two year contract. (See the Symptom & Implication, “The industry leaders are losing share” on StrategyStreet.com.) Wisely, Apple kept its old iPhone3 GS on the market as a lower-cost product, selling for $99 with a two year contract.

Competitors have been stumped trying to outflank Apple with new and better functionality. Apple simply has too many apps for most competitors. Only the Android phones, using the Google operating system, have gained share. Nokia and Research In Motion have both lost substantial share in the smart phone market. So, what are the competitors to do? (See the Symptom & Implication, “Competitors in formerly underdeveloped markets have begun meeting one another” on StrategyStreet.com.)

In this market, as in other Developing markets, the competitors strip out some of the expensive benefits of the product and introduce a new lower Price Point. In the smart phone market, the new lower Price Point still delivers one of the most important benefits of a smart phone, internet access. Because these new Price Points have fewer benefits, they cost less and allow the companies to sell to the carriers at lower prices than the Apple i4 product. (See the Symptom & Implication, “Low end products are gaining share of the market” on StrategyStreet.com.) In turn, the wireless service carriers offer lower priced package deals to their users when the packages include the new lower-priced smart phones.

Two developments are of note here. First, the evolution of the market. In this case, as in others, the market develops a new lower Price Point product that satisfies some of the basic needs of the current customer group. More importantly, the new Price Point attracts a new cohort of customers due to its lower prices. Second, prices decline in the market despite the fact that the market is growing very quickly. Prices are declining because costs are going down. Yes. But they are also declining under the press of competition in a market where margins are high enough to sustain lower prices with still-acceptable margins. Virtually all fast growing markets witness falling prices.

Best Buy in a Leader's Trap

2011-01-24T14:32:00.000-08:00

Few industry leaders believe their prices are too high. Often, they are right. They are usually less right in a market where prices fall. Consider GM in automobiles and IBM in personal computers in the past. At one time or another, most industry leaders will get caught in a Leader’s Trap, where they assume that customers will stay loyal to their products because the low-end products do not enjoy their quality and reputation. This assumption rarely, if ever, holds. Best Buy has been in a Leader’s Trap and its assumptions won’t hold this time either.

Through the third quarter of 2009, Best Buy was gaining market share in flat panel TVs and personal computers. However, in the most recent quarter of 2010, the company lost over 1% of its market share in televisions and computers to competitors who were discounting. (See the Perspective, “The Two Best Consultants in the World” on StrategyStreet.com.) Now, if it were just a simple low-end, low value competitor, Best Buy might not worry. But their discounting competition was Wal-Mart and Amazon. By any definition, these companies would count as peers of Best Buy in the television and personal computer retail market.

In the recent quarter, Best Buy emphasized high technology, and high margined, TV and personal computer products. Customers did not follow along. Best Buy noted that it had faced tough competition from off brand televisions at lower price points.

Best Buy could have offered private label products to compete with low-end, off brand, competitors. Its store brands include Dynex and Insignia. The company decided not to emphasize these lower-priced products in their promotions because they have low profit margins. Best Buy “failed” its customer by refusing to offer something that at least half the other competitors could and would offer. (See “Audio Tip #35: How Does a Company “Fail” in a Market?” on StrategyStreet.com.) Nor did competition “win” the customers who switched. Amazon and Wal-Mart simply took what Best Buy allowed them to take. (See “Audio Tip #34: How Does a Company “Win” in a Market?” on StrategyStreet.com.)

The result: Best Buy missed its targets and saw its stock price fall by 15%. The company lost market share to peer competitors. And its sales and profits fell in televisions and personal computers. Competitors gained strength.

Best Buy is a fine company with capable management. It won’t stay down for long. You may expect to see them leave the Leader’s Trap very soon.

A Very Rare Form of Pricing

2011-01-20T14:41:00.000-08:00

Recently, Continental Airlines introduced a new service called “FareLock.” This new service gives travelers three days, or a week, to decide whether to buy a ticket and avoid a fare increase or the risk that the passenger’s flight will sell out. In return, Continental plans to charge a flat fee of $5 for a three day hold and $9 for a one week hold. Continental is offering its passengers a Call. For a fee, the passenger has the right to buy the ticket at today’s price for a few days into the future. This is a very rare form of pricing outside of the securities market.

Every price has at least three components. Most have four. (See “Audio Tip #113: Tools to Change Pricing” on StrategyStreet.com.) The first of these components is the benefit package that the price offers. The second is the basis of charge, that is, how the company quantifies in currency what it charges for a unit of the product. The units can be a package, an individual item, a unit of time, and so forth. The third component is the list price of the product. Virtually all products also have what we call optional components, the fourth component. These optional components may, but do not have to, be a part of the product price. Optional price components include various discounts, fees, coupons and other methods of conveying a change in effective price, either an increase or a decrease, to the customer. A Call is one of the optional components of price. It occurs only rarely.

Here are some other examples:

* Some colleges have used the Call in the form of a fixed tuition price for any student returning for the four years of the student’s education. This pricing mechanism increases the college’s retention rates. (See “Audio Tip #142: Defensive Pricing Guidelines” on StrategyStreet.com.)

* There are also contingent Calls. Waterford Development Corporation was dealing with a difficult real estate market. It offered to have homes re-appraised two years after the date the transaction closed. If, after two years, the price of the home dropped, the company promised to write the buyer a check for up to 15% of the original sales price. With this Call, the customer gained the right to live in the house and yet pay a lower effective price for the house if the market should decline in the next two years. (See “Audio Tip #151: Changing Performance and Price Together” on StrategyStreet.com.)

* A discount broker, in an effort to attract more high-volume traders, offered a Call. This broker charged the customer only a single commission for multiple trades of the same stock on the same side of the market on the same day.

Google at Risk

2011-01-13T15:55:00.000-08:00

Google continues to dominate the search market. It commands about two-thirds of all the searches done on the internet. Its next closest rival is Microsoft’s Bing which, at 28% market share, includes its integration with Yahoo’s site. (See “Audio Tip #9: Introduction to Step 3 of the Basic Strategy Guide” on StrategyStreet.com.) Google’s dominance in this market has brought with it a disproportionate share of the spending on paid advertising. Google may be putting that premium position at risk.

Google has been investing heavily in developing its local search capability. It hopes to gain even more advertising dollars by making this investment. Now the problem. Some companies, who also specialize in local marketing have begun complaining that Google discriminates against their sites in favor of Google’s own local search results. This is a very dangerous development for Google. It risks its Reliability reputation.

Google’s competitors have had a difficult time gaining market share against Google. As competitors develop new Functions, Google simply copies them. Internet searchers have had little reason to shift from Google to other competitors, including Bing. In our terms, Google’s competitors are not able to take market share away from Google by “winning.” (See “Audio Tip #32: Introduction to Step 7 of the Basic Strategy Guide”) They have not been able to do anything unique that causes a substantial portion of customers to shift their searches to Google. Rather, most of the market share that shifts in this market today comes as the result of a “failure.” Google must fail to meet its searcher’s expectations in order for Bing and the other competitors to have a significant opportunity to gain market share.

Google may be creating this opportunity by risking a failure in Reliability. A searcher has to know that Google will provide the most relevant results. If Google offers up its own less relevant results ahead of other web sites’ more relevant results, Google will lose market share. (See “Audio Tip #72: Reliability Failures Among Outstanding Companies” on StrategyStreet.com.) Google’s actions in promoting its own results over more relevant results are equivalent to a retailer offering a customer a lower quality product over a higher quality product simply because the retailer makes more money with the lower quality product. After a while, customers catch on and defect to other retailers. A failure in Reliability is particularly troublesome because trust is so hard to rebuild.

Strangling the Goose

2011-01-10T17:04:00.000-08:00

Some time ago, we wrote a blog (see HERE) on the declining value of airline miles programs. At the time, we noted that most of those miles awarded were worth less than a cent. In fact, the airlines themselves believe that these miles are worth far less than a cent. That means the miles that you gain return less than 1% of your spending to your account.

Here is an example. United Airlines offers a one year membership in its Red Carpet Club for 70,000 miles. If you are a normal flyer, without particular value to United as a Premier or Premier Executive and so forth, you can buy a one year membership for $425. United Airlines is telling us that its miles are worth 6/10th of 1 cent.

But let’s say you are a highly valued flyer with United Airlines. Let’s assume you are a 1K flyer, one of their top categories. If you are in that fortunate (or unfortunate as you will have it) position, you may purchase a one year membership in the Red Carpet Club for $325. As an alternative, you can purchase the membership with 40,000 of your frequent flyer miles. This is a much better deal. Here your miles are worth 8/10th of a cent.

These airline-sponsored deals strike me as dangerous. (See the Symptom & Implication, “Customers are more price sensitive” on StrategyStreet.com.) They telegraph clearly that airline miles are worth less than 1%. This is dangerous because there are a number of credit cards available to you which will return 1% of your spending every month, in cash. That is a considerably better deal than the United Airline miles offer you. (See the Symptom & Implication, “New competition is entering a settled market” on StrategyStreet.com.) These airline miles keep losing their allure.

A Price Leader Market and Competitor

2011-01-06T13:52:00.000-08:00

In StrategyStreet terms, a competitor or product that offers below industry standard performance for a very low price is a Price Leader. Price Leaders contrast with the typical industry leaders who set standards for the industry, called Standard Leaders in our terms. The competitors or products at the higher end of the market are called Performance Leaders.

The Price Leader’s product has fewer benefits than Standard Leader products. Because the Price Leaders are able to save costs, their product prices average 25% to 50% below the Standard Leader’s price. Because their products do offer less than the Standard Leader product, Price Leaders, as a group, have relatively small market shares, usually less than 15% of industry sales. (See the Perspective, “Why Do Leaders Lead?” on StrategyStreet.com.)

We have analyzed several hundred Price Leaders and found that we could group them into two types, Predators and Strippers. Predators offer the user of the product Functions similar to those of the Standard Leader products but less Reliability because they sell brand names that are unknown. They offer the user equivalent benefits but the purchaser fewer benefits. Strippers offer fewer benefits to both the user and the purchaser of the product. The printer ink industry offers good examples of our Price Leader findings. The total printer ink industry has sales of nearly $22 billion a year. Something just below $3 billion of this is owned by Price Leader competitors, who refill or remanufacture ink cartridges. These Price Leaders, as a group, have 13.5% of the total market.

Most of these Price Leader competitors are Strippers. (See the Perspective, “Attention K-Mart Copiers” on StrategyStreet.com.) Customers who buy their products are often dissatisfied. In fact, only about half of the customers who try the Price Leader product are satisfied with it.

One of these Price Leader competitors, Cartridge World, is in the Predator category of Price Leader competitors. Cartridge World is a leader in the cartridge refill and remanufacturing industry. As a general rule, the company prices its laser cartridges at 25% off of the cost of a new brand named cartridge. Its ink jet cartridges come with discounts of 30% compared to a new brand named cartridge. Its Function benefits are the same as the Standard Leader products. It offers less Reliability due to its unknown brand name. But, Cartridge World puts a 100% guarantee on its products and offers relatively high levels of customer service. As a result, the company is experiencing growth rates of 20% per annum, while its competitors grow at a much slower pace.

The Holiday Season: The Most Creative Pricing Season We Have

2011-01-03T10:18:00.000-08:00

Watch the deals that retailers offer during the Christmas season. They find ever more creative ways to get us into their stores and shopping. I want to note a couple of these creative ways.

But first a bit of context. A price has four typical components: the package of benefits the product or service offers the list price, the basis of charge for the product (i.e. the unit in the dollars per unit in the list price) and, usually, some optional components of price. The optional components of price are helpful to companies who want to change the effective pricing for a customer. The retailers in this note are making creative use of some optional components of price.

The first example is the use of price to get people into stores by offering them a particular deal. Sometimes these are simply Loss Leader products, for example, offering very inexpensive bread and milk sold at the back of a grocery store in order to get a shopper in to buy other products at the store. So, one optional component of price is a Loss Leader product. Here is a creative twist. Offer the Loss Leader product in a “flash sale” with a very limited time frame. For example:

* Penney’s ran flash sales called “7 Hour Steals” offering towels for $3.69 that normally sell for $7.99 and 70% off gold and sterling silver jewelry.

* Banana Republic stores offered 40% off full-priced sweaters from 11 a.m. to 2 p.m.

Other optional components of price encourage multiple purchases. One way to do this is to offer discounts on all sales above a given purchase price. For example, a company might offer 20% off for all purchases above $50. A more creative, and aggressive, approach is to offer discounts that increase with the money spent. For example, a company might offer 20% off on a $50 purchase, an additional 20% off all purchases from $50 to $75 and a final 20% off on all purchases over $75. According to consumer research, many consumers would assume that they get a total of 60% off on all purchases over $75 with this offer. In fact, they get about 49% off on their total purchases. Still, a compelling deal.

In our study of several thousand pricing initiatives, we have found many of these optional components of price. They enable a company to improve its market share and margins in any price environment. These are available at StrategyStreet/Improve/Pricing/Innovation Ideas.

Sometimes Smaller is Better

2010-12-13T15:16:00.000-08:00

Retailers suffered through the last two years with low or declining sales as typical consumers struggled with an economy in the doldrums. Some of these retailers experimented with cost cutting and discovered an innovation for customers.

As retail demand fell, some retailers decided to reduce the size of their stores and cut their inventories to fit the smaller market they were facing. One company, Anchor Blue, put in temporary walls and cut its selling space in half. This certainly saved them money. It also provided a big surprise. Anchor Blue found that its foot traffic rose by 7% and sales increased by 23% after the remodel.

As other stores had the same experience, bigger chains began their own small-is-beautiful experiments. Bloomingdales and Nike are both trying smaller stores. Retailers are reducing their inventories by removing the slower moving items. These changes enable their customers to find, choose and pay for their products faster. In other words, the smaller stores are a Convenience innovation that customers seem to like.

We seem to be reaching a limit in the retail world. For the last generation, retailers grew by increasing Functions in ever-larger stores. (See the Perspective, “When to Compete on Features” on StrategyStreet.com.) They added categories and assortments to increase customer choices. These Function innovations demanded more space. More choices and space added to the time customers had to spend at a store. The Convenience innovation of the smaller stores suggests that customers have reached saturation points with the larger stores offering more choices. Sometimes smaller is better. (See the Perspective, “Is Bigger Really Better?” on StrategyStreet.com.)

Nokia Makes a Bet in the Smart Phone Market

2010-12-06T10:41:00.000-08:00

Nokia has a big problem in the smart phone market. It has to do something to change its outlook. It just made a bet with the choice of its pathway to the future.

Nokia produces both the hardware and the operating system for smart phones. Its hardware is the handset and its software is either the Symbian or MeeGo operating systems. The company uses the Symbian software with its less advanced smart phones and the MeeGo system for the more advanced and more expensive phones.

Nokia is losing market share rapidly, especially to phones using Google’s Android operating system. Over the last year, the Symbian operating system’s market share fell from 45% to 37% of the market. In the meantime, Android has garnered 25% of the market, up from less than 4% a year ago. Nokia developed the MeeGo system to counter the flowing tide to both the Android and the Apple operating platforms. These platforms from Apple and Android have nearly shut Nokia out of the high end smart phone business in the U.S.

Nokia has decided against adopting the Android operating system for its phones. It is afraid that the adoption of Android would leave it competing in an increasingly less attractive hardware market, while the profits go to the operating software manufacturers. Nokia is undoubtedly right here. (See Video #3: Predicting the Direction of Margins” on StrategyStreet.com.) The question is, can they catch up fast enough?

Nokia is working hard to get the MeeGo system up to speed for developers. Today, the developers feel that the MeeGo operating system is in its early stages. It is attractive, though, because this operating system supports a number of different products that consumers use, including tablets, televisions and phones. And Nokia has acquired and developed software, called QT, that enables software developers to write an application once and have it work on a number of hardware products.

Nokia has time to get this right. The smart phone market is still a high-end, Performance Leader, product. It will take time for the mass market to adopt the smart phones and their operating systems. Nokia has a large base of customers using its phones and operating systems. Most of these customers would prefer not to leave a supplier they have come to know and like. If Nokia can pull its act together quickly, it can be a strong performer. And, certainly, there will be room for three operating systems in this market. In fact, if Nokia does well, it could still end up the long term leader, a position it has owned in the cell phone market for the last several years. Failing that, it has a reasonable chance to beat out the Apple operating system over the longer term. To accomplish this, Nokia must develop and use its superior economies of scale to price its products aggressively to take share again. (See Video #53: Productivity and Economies of Scale in Hostility” on StrategyStreet.com.)

But, there is a lingering question. Why not hedge the bet by developing Android phones as well? They could maintain good economies of scale and keep handset profits if their software bet fails.

Abercrombie - Recovering in a Falling Price Environment

2010-12-02T15:55:00.000-08:00

Nearly two years ago, we began a series of blogs about Abercrombie & Fitch (See Blogs HERE, HERE and HERE). Abercrombie & Fitch had been in a Leader’s Trap, where the company held prices high despite the onslaught of discounting competitors, including Aeropostale and American Eagle Outfitters. (See “Audio Tip #119: A Price Umbrella” on StrategyStreet.com.) The discounting competitors gained share while Abercrombie & Fitch lost it, sometimes in handfuls. In fact, all throughout 2008 and 2009, sales at stores opened at least a year declined.

We predicted in the original blog that Abercrombie would have to come out of its Leader’s Trap and discount its prices to keep its competitors at bay. (See “Audio Tip #118: The Leader’s Trap” on StrategyStreet.com.) In the spring of 2009, the company did begin discounting its prices to stop its share loss. These discounts gradually brought business back to the stores so that stores opened at least a year began to see sales increase rather than decrease during 2010. In fact, the company has found that, while it cut its prices by 10% or more, it still generated higher sales because the growth of unit volume made up for the price cuts.

The company was judicious in the way it went about reducing its prices. It discounted its prices in the United States to narrow the price gaps it had with its competition. On the other hand, it held its premium price position in its overseas markets. Prices for the same item of clothing are 30% to 50% higher in London and Tokyo stores than they are in the U.S. Abercrombie & Fitch’s international customers can not take advantage of the low U.S. prices because they can not reach the U.S. domestic internet sites of the company. Instead, international buyers searching on the internet for the company’s online stores are automatically redirected to their local company web sites of Abercrombie & Fitch.

We liken the task of pricing in a falling price environment to a game of darts. In the game of darts, the circular dart board is broken into several pie-shaped areas. The players must aim for a particular area that changes with each turn. Within each of these areas on the dart board, the more narrowly the player can target his dart, the more points he accumulates on the turn. Of course, the dart is the vehicle to hit the target area with precision. In pricing, the target area is a segment of customers. These segments reflect particular competitive situations the company faces rather than needs of the customers themselves. The darts are the components of price that the company can use to hit the target segment with precision. These price components include the set of benefits in the product, the basis of charge for the product, the list price of the product and several optional components of the price. The combination of the segment and the component of price the company uses to hit the segment limits the scope of the price reduction to those customers who absolutely require it. This precision pricing reduces the impact of the price reduction on the company’s margins. (See Improve/Pricing on StrategyStreet.com.)

Abercrombie reduced U.S. prices to meet U.S. competition. It did so by reducing some list prices and introducing new, lower priced, products to compete in the U.S. market. Overseas, however, it held its prices high because competitive conditions allowed it to do so.

Now we will wait to see whether Abercrombie regains the market share it lost to its discounting competitors in 2008 and 2009.

A Fast Growing Market Begins Developing Reliability and Convenience Innovations

2010-11-29T16:12:00.000-08:00

In a fast growing market, new Functions and lower Price drive more share gains than do Reliability and Convenience (see Customer Buying Hierarchy descriptions on StrategyStreet.com in the Perspective, “How Customers Buy” and in “Video 25: Short Explanation of Customer Buying Hierarchy”). After awhile, though, market growth begins to slow and Function innovations become less important than innovations in Reliability and Convenience. We can see this developing in the wireless applications market.

This market has been on a tear for the last few years. Recently, Amazon announced that it was planning to enter the market for phone applications by creating an online store selling apps for smart phones running Google’s Android software. Amazon will then compete with Google’s web site offering apps that work on the Android system.

Amazon’s entrance shows developments in both Reliability and Convenience. Amazon offers Reliability innovations in at least two ways. First, Amazon encourages the reviews from its customers of the products it sells. These customer reviews are important sources of Reliability information about a product. Second, Amazon insists that any app it sells will not sell for a lower price anywhere else. This Reliability innovation assures a customer that Amazon will have prices that are competitive with anyone.

Amazon also brings great Convenience to this market. There are so many apps today that the market is becoming chaotic. Amazon will organize these applications in ways that fit with its customer base. Amazon has a long history of doing this very thing with other products. Just as importantly, Amazon already has a working payment arrangement with millions of customers. It is particularly adept at the “one click” payment system, which enables a customer to pay for purchases very quickly.

Amazon’s entry is a good example of a natural evolution in a fast growing market.

Costs - The Problem with Weak Constraints

2010-11-22T14:25:00.000-08:00

Here are two random observations of the results that any manager can expect to face when there is little to no constraint on the level of costs in an organization.

The first comes from the Heritage Foundation. This foundation analyzed the percentage of jobs gained or lost since January of 2008 through July 2010, a time of recession. The foundation measured job growth in the federal government, state government, local government and the private sector. The private sector was under extreme constraints as revenues flattened or shrank. This sector lost 6.8% of its jobs. Local government was under pressure from the fall-off in property tax receipts. This sector lost a little less than 1% of its jobs. State governments suffered from falling income tax revenues as the recession flattened consumers and commercial tax payers. It lost one tenth of one percent of its jobs. Then there is the federal government, who operated without constraints by creating debt. In just the two and a half year period, total federal government employment increased by 10%. Shocking.

The second observation is also a great source of concern. This data tracks the performance of public schools, K through 12, from 1970 to 2010, forty difficult years. Voters of all kinds have tended to support public education. This support shows up in both spending on the public school sector and in its employment. Since 1970, the real spending, that is after adjusting for inflation, on public K through 12 education has increased by 150%. (See “Audio Tip 195: Economies of Scale and Their Measurement” on StrategyStreet.com.) The total employment has increased by about 100%.

Did we get any more for that additional spending? Enrollment increased by about 5%, after having fallen for the first twenty years of the measures. So, productivity, as measured by employment divided by enrollment, declined a great deal. But perhaps there was more benefit in the quality of the education? It turns out that hasn’t happened either. The scores for science, math and reading have not moved at all, despite the increase in spending.

In both of these examples, we seem to be spending without accountability. (See “Audio Tip 198: Diseconomies of Scale” on StrategyStreet.com.) As much as you can criticize the budgeting system of most businesses, results like these are highly unlikely to occur over a period of time in business systems because there would be quick accountability with this kind of loss in productivity. If that accountability did not come from within the business then, surely, competition would call the profligate business to account.

I Guess it Takes Bankruptcy...

2010-11-18T15:55:00.000-08:00

In our previous blog (see Here), we described the resuscitation of the comatose manufacturing employment due to renewed flexibility in many union shops, such as GM. I guess it takes bankruptcy to get attitudes to change. Look at American Airlines, for an example.

Over the last several years, its big airline competitors have been getting bigger. United and Continental combined, as did Delta and Northwest. U.S. Airways merged and Southwest has just purchased Air Tran. Through it all, American stood largely on the sidelines.

Most of the other competitors had a real advantage. They went through bankruptcy. Of course, Southwest did not, but the other legacy carriers did. What those airlines and their workforces learned in bankruptcy created a lower cost and more flexible set of work rules for these airlines. Now American Airlines is beginning to pay the price for its competition with lower cost airlines.

American is clearly a high-cost airline. Its 2010 cost to fly a seat mile is 12.76 cents. This is the highest among the six largest carriers. Predictably, its pretax margins for the first half of the year were negative, while its peers produced positive operating earnings.

The problem American faces is primarily due to high labor costs. This may surprise you since several of the unions agreed to give-backs in 2003. Further, the American Airlines pilots claimed to be working at 1993 hourly rates. In short, all the unions working at American seem to be up in arms in frustration over their lack of economic progress.

The problem is less the rate of pay for the workforce than it is the work rules. American is at the bottom on industry measures of productivity because of restrictive work rules. Does that sound like the American automobile industry’s problem before the recent spate of bankruptcies?

Still, the unions are up in arms. Despite long term negotiations, the company has reached little in the way of agreements. Some unions are now threatening a strike. Let’s see. Take a high cost airline that is losing market share, increase its costs and scare away its future passengers with a threat of a strike. That sounds like a prescription to insure the future of an airline and the jobs that go with it, doesn’t it?

Green Shoots and Attitudes and Jobs

2010-11-15T16:14:00.000-08:00

Here is something that may surprise you. We are now gaining manufacturing jobs in the U.S. Manufacturing employment has fallen every year since 1998, until 2010. Since the beginning of 2010, there has been a 1.6% gain in manufacturing jobs. That’s twice the pace of the growth in other private sector jobs. The unemployment rate for the manufacturing has improved from 13% in December of 2009 to 9.5% in August of 2010. That’s a better performance than that of the overall labor force.

These gains have come primarily in four industries: automobiles, fabricated metals, primary metals and machinery. These industries have all been losing jobs for several years. What is behind the change? Here is a significant indicator. Recently, the United Autoworkers Union has crafted an agreement with General Motors to encourage GM to invest money to assemble a low-priced sub-compact car in the U.S., with unionized labor.

This will be a first. All other domestic and foreign manufacturers have produced their sub-compact cars offshore. GM’s sub-compact, the Aveo, came from South Korea. Ford’s Fiesta came from Mexico. Chrysler and Fiat are planning to manufacture the Fiat 500 in Mexico. The Honda Fit and the Toyota Yaris are imported from outside the United States.

This new agreement is truly ground-breaking. Under the terms of the agreement, GM will pay 60% of the sub-compact plant’s 1550 workers a wage of $28 an hour. The other 40% of the plant’s employees will make $14 an hour. By GM’s calculations, this would enable the company to build a sub-compact at a profit in the U.S.

This new agreement may, in fact, reduce the average wage rate to competitive levels. Before GM’s bankruptcy, the average GM worker earned over $70 an hour in wages and benefits. After bankruptcy, that rate of cost fell to about $57 an hour…good, but not good enough to compete profitably. (See “Audio Tip #163: Introduction to Step 25 of the Basic Strategy Guide” on StrategyStreet.com.) Toyota has average labor costs of about $50 an hour. The Toyota workers are not unionized. This new UAW agreement with GM should make the new sub-compact plant competitive with the cost that Toyota incurs in the U.S.

A change in attitude at the UAW is behind this job-creating agreement. A senior UAW official explained that this agreement was the result of some very difficult decisions the union had to make in order to safeguard jobs. He further explained that the UAW developed a new understanding of the realities of the 21st century global auto industry while living through the GM and Chrysler bankruptcies. (See the Symptom & Implication, “The industry is reducing costs aggressively” on StrategyStreet.com.)

Three cheers for the UAW/GM agreement. Let’s hope that it creates jobs and profits.

The ETF Arms Race

2010-11-11T15:09:00.000-08:00

In our previous blog (See Here), we discussed Vanguard and its unseating of Fidelity as the largest money manager in the U.S. Vanguard has done this with low-priced attacks on virtually every market Fidelity serves. Fidelity, and much of the rest of the market, is allowing Vanguard to get away with this, at least for now. In this blog, we want to see how pricing affects even a fast-growing market and then watch what happens when a Vanguard flexes its muscles in such a fast-growing market.

Exchange Traded Funds (ETFs) are some of the hottest products in the financial industry today. They are cheaper and, often, more tax efficient than are mutual funds. Because of these advantages, many independent registered investment advisors and individual investors have shifted out of mutual funds and into ETFs. The ETF market is growing rapidly.

A year ago, Schwab decided to take share in this market by using low prices. Schwab offered eight ETFs to its customers on a commission-free basis. Since Schwab is such a leader in the market, the company’s move started a war. (See the Symptom & Implication, “The industry is seeing its first price wars” on StrategyStreet.com.) In short order, E-Trade, Fidelity and Vanguard joined the fray. Fidelity offered twenty-five iShares ETFs, commission-free. Recently, TD Ameritrade upped the ante. This company offered more than one hundred ETFs, commission-free, to both individual investors and investment advisors. This is a real arms race in the fast-growing ETF market. Prices on already inexpensive ETFs continue to fall.

Why this focus on industry prices? The industry has learned that high prices cost you market share. This is a sure signal that customers are having increasing difficulty making buying decisions among the top industry ETF providers on the basis of Function, Reliability or Convenience. When an investor can not chose among peer competitors on the basis of performance, that is Function, Reliability or Convenience, they make their decisions on the basis of Price. (See the Perspective, “What Ends Hostility” on StrategyStreet.com.)

In this price war, Vanguard stands to gain the most, at least in the short term. This company is well known for its low-cost funds. So far this year, Vanguard has garnered 37% of the new money coming into the ETF market. Their 37% share of new money is greater than the combined shares of the two biggest ETF companies, iShares and State Street Global Advisors, combined.

For their part, the top two ETF sponsors argue that they will not be drawn into a price war. This is simply a Leader’s Trap. You can ignore these protestations. They, and everyone else in the market, will have to respond to Vanguard, or stand aside and watch Vanguard trample them in the market.

Vanguard vs. Fidelity

2010-11-08T14:29:00.000-08:00

We are going to use this blog, and the next one, to speak more about pricing. Over the years, we have learned some surprising things about pricing. For example, in the average market, price moves much less share than most people assume. (See the Perspective, “The Price Segment” on StrategyStreet.com.) In most markets, the true price-driven market share volatility is 15% or less of the current volatile, changing, market share. You might ask how that can be. But the explanation is relatively easy. Most of us buy most of the things we purchase on the basis of a unique Function, better Reliability, or more Convenience, before we even get to Price. Did you buy your last car on the basis of Price? How about those snow skis? Were they the cheapest on the market? Do you stay in the cheapest hotels or drink the cheapest beer? True Price buyers are in the minority. And before these buyers get to Price in the decision sequence, they have satisfied themselves that there is no important difference among competitors on Function, Reliability or Convenience.

Even more surprising to most people is that in a hostile market, one with severe overcapacity and intense price competition, price moves even less share. We have worked in many hostile markets. In all of them, the true price-based volatile market share was less than 5% of the available volatile share. The reason for this phenomenon is that in a true hostile marketplace, virtually all competitors have learned to copy lower prices, or face an immediate loss in market share. (See the Perspective, “Why Price Cuts Don’t Build Share” on StrategyStreet.com.) For an example, look at the airline industry. When one airline offers a price discount, all the other peers of that airline offer the same discount on the same flight to the same locations.

Now I am going to offer what seems to be an exception to these “guidelines” I have just set down. The exception appears to be Vanguard in its competition with Fidelity Investments and the other money managers. This year, Vanguard Group replaced Fidelity as the largest U.S. mutual fund company. Fidelity had held that number one ranking since 1988, when it passed Merrill Lynch. At one time, the Fidelity Magellan fund, while it was run by Peter Lynch, was the world’s largest mutual fund. In 2000, it reached $110 billion under management. Lynch had a phenomenal record, but his successors did not. Today, the Fidelity Magellan fund has less than $30 billion under management. The biggest mutual fund today is the Vanguard 500 Index Fund at $87 billion under management.

The big difference between a managed fund and an index fund should be performance. A managed fund is supposed to earn more than an index fund. Some do, most don’t. So many investors have been migrating to the lower-priced index funds. Stock index funds charge an average of 29 cents per hundred dollars invested. Actively managed funds charge more like 95 cents.

Vanguard has unseated Fidelity by offering low-cost funds. Fidelity offers mostly managed funds. Vanguard is the ensign bearer for index funds. Investors seem to pay more attention to management costs when returns are already low. Over the last ten years, Vanguard has taken in more than $4 in new money to manage for every $1 Fidelity has gained. Almost 80% of the new money coming to Vanguard this year went to index funds. Exchange traded funds, ETFs, are even cheaper than many index funds. Vanguard has over $100 billion in ETF funds. Fidelity has side-stepped that business.

So Vanguard appears to be winning in the market due to pricing. How does that jibe with the guidelines we talked about? The key rule is that a customer does not buy on Price until after the customer has satisfied herself, that there is no important difference to the customer on Function, Reliability or Convenience, so the customer decides on Price. Vanguard has proven to many investors that it is the Functional equivalent of Fidelity, that its returns are Reliable and that it is equally Convenient to purchase, so many customers buy on Price. The price markets here are the index funds and the exchange traded funds. Fidelity needs to offer exchange traded funds to stay in the game. What really is happening is that Fidelity is “failing” on Price while Vanguard beats the other competitors on the basis of Reliability and Convenience.

Previews of Coming Attractions in Public Services

2010-11-04T14:56:00.000-07:00

A generation ago, public servants earned less than equivalent employees in the private sector. This is no longer the case. Many reports today suggest that public servants earn 25% or more greater compensation than equivalent private sector employees. While a percentage of the workforce employed in private industry union shops has steadily declined for more than thirty years, unionization in the public sector has grown rapidly. This is important because of the inflexibility of many unions in changing work rules and compensation when confronted with economic realities such as tightening budgets.

What might you expect to happen in such an environment? Growth of private sector companies offering the same services, or better, for less money. These private companies operate under the price umbrellas of the public sector. That is certainly happening today, even in the most unlikely of places. A little company in Maryland has grown into the country’s fifth largest library system, measured by number of branches. This small company, Library Systems and Services, Inc., runs fourteen library service systems operating 63 branches. It has $35 million in annual revenue and 800 employees. It ranks behind Los Angeles County, New York City, Chicago and the city of Los Angeles in the size of its branch system.

The company is finding it relatively easy to succeed by cutting overhead and replacing unionized employees with non-union employees willing to do the jobs for less. In a recent $4 million contract, the company pledged to save $1 million a year using its cost reduction techniques. (See “Audio Tip 187: The Components of Productivity” on StrategyStreet.com.)

Nor does the company need to reduce hours and services in order to succeed. The company has found that the operating policies of public libraries often serve to protect job security and ensure high rates of pay. (See “Audio Tip 182: Productivity as a Measure of Physical Costs” on StrategyStreet.com.) Of course, not all people are happy with the success of this company. In particular, the company’s most recent contract came in for severe criticism from the Service Employees’ International Union. That union has 87 members in libraries recently transferred to Library Systems and Services.

As the cost of public employee pay and pensions becomes less bearable in the future, we can expect to see a good deal more of companies like Library Systems and Services. These private companies should also be good investments. Their first need is not to generate greater revenues, though I am sure they will try that. Instead, they need only reduce costs. That should be relatively easy, due to the price umbrella held up by current public sector management of citizen services.

Dominick’s Finds a Way to Reduce Price…Successfully

2010-11-01T12:21:00.000-07:00

Dominick’s is a wholly owned unit of Safeway, the large retail grocer. They have found a way to use price to gain share in a highly competitive price environment.

If a company wishes to use a discounted price to gain market share, it must assure itself that its competitors will not copy its price reduction. If a competitor copies the price reduction, then the original company’s discount is no longer distinctive and cannot drive a gain in share. Instead, its low prices cause its margins to fall without the offsetting benefit of increased sales volume.

You would like to be able to predict whether a competitor will copy a discount you offer. In the course of many pricing studies, we have found that the likelihood of a competitor responding to a company’s price reduction depends on three factors: the competitor’s knowledge of the price reduction, the company’s capacity to meet that price reduction and, often most importantly, the competitor’s will to meet the lower price. (See “Diagnose/Pricing/Competition and Their Knowledge, Capability and Will” on StrategyStreet.com.)

If your competitor does not know about your price reduction, they can not respond in kind. In some markets, customers do not “shop” a lower price offering to their suppliers in what’s called “last look” Their suppliers may not respond to a competitor’s lower price offering because they do not know of it. The competitor also must have the capacity to respond to the lower price. In the vast majority of falling price environments, most competitors have ample capacity to respond to lower prices. Still, some competitors are unwilling to meet falling prices in an industry. These competitors are in a Leader’s Trap, where they assume that the lower prices will not attract their customers. This is virtually always a losing assumption. The phenomenon of the Leader’s Trap leads us to the third determinant of the likelihood that a competitor will respond to a lower price: does the competitor have the will to do so. A competitor needs the will to do so because its margins are likely to fall, even if it maintains its current market share. Some competitors refuse to suffer the margin consequences and live, at least for a time, in a Leader’s Trap. (See many examples on StrategyStreet/Tools/Grossary/Leader’s Trap)

So, it is difficult for a company to use a low price to gain market share. Difficult, but not impossible. Dominick’s has found a way. Dominick’s is in a price war, not only with traditional grocers, but also with Wal-Mart, Target and discount stores. These competitors of Dominick’s often have lower prices on categories of consumer purchases that Dominick’s would like to sell to their own customers.

Dominick’s has used its “Frequent Shopper Card” information to help it offer low prices to very targeted customers. It analyzed the shopping patterns of its frequent shoppers. It found that some of its customers have assumed that supermarkets are not competitive in some high-priced, high-margin products. These customers then start buying those categories from discount chains and spending their retail grocery money on perishables like milk, meat and produce. Dominick’s used this information to offer shoppers personalized savings on items they have purchased in the past and could purchase again. The store offers these shoppers very competitive discounts on products, which are profitable for Dominick’s, but that customers purchase from other competitors. The shopper is offered a very good deal. The offer comes automatically at the cash register when shoppers use their loyalty cards. The offers are good for up to ninety days on unlimited quantities of the discounted items.

Dominick’s is gaining share with this program because competitors do not have the knowledge of the lower prices. These low prices are not advertised, nor are they available to all shoppers. Instead, they are personalized offers, targeted at customers who are likely to use them soon. These same customers tend to buy these discounted products from other suppliers, assuming that Dominick’s is not price competitive with those other suppliers. Dominick’s picks up some extra sales that pay for the selective discounts it offers and competitors are unable to respond because they do not know about the discounts.

Microsoft Phone 7 - A Long Row to Hoe

2010-10-28T14:15:00.000-07:00

Recently, Microsoft introduced Windows Phone 7 Mobile software. This is all new software that Microsoft hopes will stop its slide in market share. It is going to have tough sledding.

Until this introduction, Microsoft’s market share in the mobile software business was dropping off a cliff. The company was one of the early entrants into the market. In 2004, it owned 22% of the market. By 2009, its share was down to 9%. Today it is about 5%. Microsoft was quickly fading away. But maybe the new software can help.

For a bit of perspective, we have to explain that there are five separate players involved in this marketplace: the operating system developers, the phone manufacturers, the wireless carriers, the software application developers and the ultimate users. Each of these entities are in separate businesses and represent separate competition. Microsoft plays in the market exclusively as an operating system developer. That’s what Windows Phone 7 is. The Google Android system is another stand-alone mobile operating software platform. So has been Hewlett Packard’s Palm mobile operating software. Three other competitors offer their operating software only in combination with their handset hardware. These include Nokia, with the Symbian operating system, Research In Motion’s Blackberry products and Apple’s iPhones.

The market share ranking today among those competitors in total operating software starts with Nokia’s Symbian, followed by Android, then Blackberry and Apple. Each of these has a market share that are multiples of Microsoft’s current share. Microsoft is fifth, followed by Palm and others.

The new Windows Phone 7 software is a wholly new product. It is completely different than the previous Microsoft mobile software. So different, in fact, that none of the thousands of applications written for the previous Microsoft software will work with Windows Phone 7. The company must start from scratch with applications.

Consumers love applications and make many of their buying decisions on the basis of these applications. (See the Perspective, “When to Compete on Features” on StrategyStreet.com.) Today, Apple has about 250,000 applications, followed by Android with about 70,000. The differences between the two are probably much less than these numbers would indicate because most of the popular applications are available on both platforms. You can see this in the marginal purchases. Android garners more of the current new purchases than does Apple. So, for all practical purposes, Apple no longer owns a significant application lead on Android.

Windows Phone 7 faces a real hurdle with applications. In some ways, it offers a few benefits over the Android and Apple operating systems. For example, it works off of “tiles” that enable a user to get information somewhat faster than in the Android and Apple software. It works easily with Microsoft Office software and it enables gamers to connect to online games easily. These are modest innovations at best, and likely to be followed by others quickly. For example, Motorola already produces software for its phones that pretty much duplicates Microsoft’s “tiles.” Apps are the big problem.

If you are an applications developer, Microsoft would likely be far down your list of the companies for whom you would write new application software for a smart phone. Android and Apple would lead the pack. Nokia, Research In Motion and others offer more current customers than Microsoft but pose difficulties for developers. Microsoft would fall below all these firms. Microsoft has to solve this problem quickly.

Application developers are also likely to be leery of Microsoft and its continued presence in the market. Not only has the company lost share, but it introduced a software platform called Kin in the spring of 2010 aimed at young people, between 12 and 20. This product did not stay in the market even two months. So developers are likely to hold fire on their application development for the Windows Phone 7 platform until they are relatively sure that the product will succeed.

Microsoft is backing its Windows Phone 7 introduction with a $100 million advertising program emphasizing the ease with which a user can get to the information most important to the customer. This seems to me to miss the mark. This advertising investment is a Convenience innovation that advises the customer why the Microsoft system is faster and, therefore, better. (See “Video 15: Definition of Convenience” on StrategyStreet.com.) But it seems that most of the smart phone purchases today are the result of other current users’ recommendations and demonstrations. This is a Reliability innovation. These current users are apt to emphasize the Function benefits of their phones rather than the speed of access to information.

Microsoft might have spent this money differently. It is already paying some developers to create applications for its platform. My guess is that their $100 million might have been much better spent paying for applications, where Microsoft is likely to fail on the basis of lack of Functions rather than paying for the Convenience innovation of advertising.

The Fall of an Industry Leader - Part II

2010-10-25T16:26:00.000-07:00

The Fall of an Industry Leader - Part 1

2010-10-21T13:39:00.000-07:00

Blockbuster declared bankruptcy in September of 2010. According to reports, the company was done in by the online service of Netflix and the in-retail store kiosks of Red Box. That is only partly true. The company was done in, first by its failure to recognize and respond to market opportunities when others created them and, second, by its determination to extract higher prices than its performance in the market warranted. Its failure as a company was a long time coming. It started in the late 1990’s. Since 2002, the company has lost more than $4 billion. Its market value fell from $4 billion eight years ago to just $12 million at the time of the bankruptcy.

In this, and the next blog, we are going to look at Blockbuster’s history. We will only touch on highlights, but the highlights explain much of the story.

We will begin by looking at Blockbuster’s product and service offering over the last twenty years. (See “Basic Strategy Guide Step 7” on StrategyStreet.com.) Here are some of the highlights:

* The video rental market grew very quickly throughout the 80s and the early part of the 90s. By 1993, Blockbuster had 600 stores. It was adding a store a day to that total. In doing so, it was squeezing out of the market many small video stores.

* The first video dispensing machines, precursors to the ubiquitous Red Box kiosks, came out in the mid-80s. They were introduced by Group One using a vending machine produced by Diebold. By 1990, there were many of these machines. 70% of them were available 24 hours a day. Each machine had about 400 tapes available. Blockbuster had none of these machines. (Note: after a very late response, Blockbuster Express now has 7000 kiosks, also made by Diebold.)

* In the mid-1990s, Direct Broadcast Satellite offerings of movies began to cut into the Blockbuster demand. To make up for the slowdown in demand, Blockbuster added music, books, software, movie shirts and mugs. All were failures.

* In 1998, Netflix launched its service. The company grew very rapidly, and was introduced to the public stock market in 2002. At the time, Netflix had less than a million customers. Blockbuster had 8,000 stores world-wide. As late as 2002, the CEO of Blockbuster dismissed the Netflix product as a niche offering.

* In 2001, Netflix, though still tiny, had a far more extensive movie selection than the average Blockbuster store. At the time, Netflix offered a choice of 10,000 separate movies, about ten times what the largest Blockbuster store could offer. In addition to offering more choices, Netflix also provided customer and professional movie reviews and a service that predicted what movies subscribers would like based upon the subscriber’s reviews of previous movies. Blockbuster offered none of these additional services.

* Later in 2002, Blockbuster began to test an online offering, but decided not to enter that market. Instead, it offered the Freedom Pass product, which required customers to go to the store to pick up and return their movies. The Freedom Pass offered unlimited movies for $25 a month. Blockbuster had 9,100 world-wide stores. 70% of the U.S. population was within a ten minute drive of one of its stores. At the same time, Netflix offered its unlimited movies, three movies at a time, service for $20 a month.

* By 2002, Netflix could offer overnight service to 50% of its customers and promised to reach 70% of them with that speedy service within a year.

* In 2003, Blockbuster updated its Freedom Pass program. It offered two movies at a time for $20, three movies at a time for $30. It introduced this program in all 5,500 of its U.S. stores. In the meantime, Netflix reached a count of 1 million subscribers by charging $20 a month for three movies at a time. The Netflix price was 33% lower than Blockbuster’s.

* By 2004, Blockbuster was stumbling badly in its earnings. It held back on inventory, so many popular movies were often out, frustrating customers. (See “Video 54: Cost Reduction by Winners vs. Losers in Hostility” on StrategyStreet.com.) During this year, Blockbuster finally enters the online market, six years after Netflix entered.

* During the period of the early 2000s, Hollywood studios began selling DVDs at relatively low prices. At the same time, the cable companies were offering online movie streaming through their cable boxes. Both of these developments reduced the demand for Blockbuster’s products.

* In 2004, Netflix reached 2 million subscribers and was growing at 80% a year.

* By 2005, Blockbuster was becoming desperate for revenue and margin. The company added video games, DVD sales and DVD resales to its product line. Blockbuster’s online business was flourishing with 1 million subscribers. But Netflix had 3 million. Wal-Mart decided to leave the online rental market and directed its customers to the Netflix program.

* In 2008, Blockbuster offered an online streaming service. To access the service, customers had to purchase a T.V. set-top box for $99 and then pay regular movie fees for each movie they watched. Blockbuster claimed that the T.V. set box was free because they offered a credit for 25 movies to anyone purchasing the box. At the same time, Netflix offered its movie streaming service free to its regular subscribers.

* By 2009, Blockbuster was closing stores at a rapid rate, becoming less convenient for many customers. Netflix and Red Box continued growing rapidly. At the time of its bankruptcy, Blockbuster was down to 3,300 U.S. stores, and falling.

What does this story tell us? In the early years, until the early 90s, Blockbuster was a very successful company. It won, streamlined the video rental market and became the unquestioned industry leader. It then became complacent. It ignored the new channels of distribution, including vending machines, online rentals and video streaming. Other people developed and refined the cost structures of those markets. Blockbuster did eventually enter these channels, but by then it was too late to play catch-up.

In the next blog we will look at Blockbuster’s pricing history to see how that contributed to its failure.

Market Share Volatility in a Fast Growing Market

2010-10-18T16:35:00.000-07:00

The smart phone market continues to grow quickly. The market for the operating systems on smart phones illustrates one of the patterns you will see in a fast growing market.

In order to see these patterns, we will use the Customer Buying Hierarchy. We will evaluate the reasons for market share volatility using the Customer Buying Hierarchy. Market share volatility is market share that moves from one supplier to another. (See “Audio Tip #26: Introduction to Step 6 of the Basic Strategy Guide” on StrategyStreet.com.) This market share movement may happen because new customers enter the market, where all competitors may compete for the customer, or because customers simply change their suppliers. The Customer Buying Hierarchy (CBH) holds that customers buy: Function, Reliability, Convenience and Price, in that order. (See “Audio Tip #95: The Customer Buying Hierarchy” on StrategyStreet.com.) New Functions or lower Prices dominate the causes of market share volatility in fast growing markets.

The emergence of the Apple iPhone, with the Apple operating system, illustrates the impact of new Functions. The Apple operating system virtually exploded on the market and probably created the consumer interest in smart phones. Apple was able to gain a quarter of the smart phone market very quickly on the basis of its many unique Functions, the result of the thousands of apps written for the operating system.

More recently, the growth of the Android operating system illustrates the second major driver of market share volatility in high growth markets, low Prices. The Android operating system is growing very quickly now, taking share from the Research in Motion, Apple and Microsoft operating systems. What is its advantage? It’s free. The handset manufacturers and the cell phone service providers like an inexpensive operating system. So, it turns out, do many customers. The Android operating system is now grabbing market share by the handfuls. There is no let-up in sight.

How Hostility Starts

2010-10-11T15:23:00.000-07:00

Many years ago, I had the good fortune of living in London for three years. During that time, I would often have lunch in one of London’s many public houses, “pubs” to you and me. They served rich and ample fare such as shephard’s pie, sliced turkey sandwiches and, of course, English “bitter.” Sometimes, after work, I would meet friends for a drink at the same pubs. When I traveled the countryside, I could always rely on a local pub to provide good food and drinks at reasonable prices. They were a more comfortable equivalent of a fast food restaurant. And they were great places to socialize.

Things have changed. A couple of years ago, my wife and I spent a vacation in England. I was anxious to take her to some of my favorite pubs, both while we were in London and while we were in the Cotswolds. To my surprise, most of these pubs were gone. Those that had survived had largely transformed themselves into much more upscale restaurants. Gone were the gorgonzola sandwiches and the cheddar and bread offerings. In their place were white tablecloths and nice silverware settings.

The public house is under significant pressure in Britain. The number of pubs has fallen by 10% in just the last five years. What happened? New competition.

Competition, both above and below pub prices, has reduced the market for pubs. At the lower end of the market, supermarkets easily undercut pub prices with their substantial buying power. At the higher end, the British have expanded their taste for wine. All of this new competition has reduced the sales of beer, the pub’s key product.

This is a picture of the development of a hostile market, where price competition is intense and returns for the industry are often low. A reduction in the number of competitors is a hallmark of a difficult, hostile market. We have studied many of those markets over the last twenty-five years. Most hostile markets are caused by the expansion of competition. The minority examples of hostility are the result of a fall-off in demand. The British pub industry has seen both factors at work. But the most pressing has been the expansion of competition.

For a relatively short summary of how to operate in a hostile market, see these two Perspectives: “Success Under Fire: Policies to Prosper in Hostile Times” and “Use Subtle Strategy in Tough Markets."

P&G Takes Off the Gloves

2010-10-07T16:21:00.000-07:00

Last year, Procter & Gamble suffered as consumers shifted their purchases away from P&G’s feature-rich products toward lower cost, and less feature-laden, products. Some consumer research indicates that the majority of consumers believe that the lower cost products are as good as, or better, than the higher cost products in many of these P&G markets. P&G was suffering share losses. (See “Basic Strategy Guide Step 7” on StrategyStreet.com.) Ever sensitive to the will of the consumer, P&G has shifted course, at least temporarily. Where it spent the last several years developing new features and benefits for its products, it now has determined to beat back competition with lower prices.

The price reductions are noticeable, both to the consumer and to the financial analysts. P&G reduced its prices anywhere from 2% to 13% across a broad spectrum of products, including laundry detergent, fabric softeners, sanitary napkins, shampoos and conditioners and batteries. The price reductions have reversed Procter & Gamble’s loss of market share. It is maintaining or gaining market share in the majority of its markets today but analysts and competitors are crying “foul.” These price reductions have taken a significant toll on the relatively rich margins at P&G. Margins on these products have probably fallen between 20% and 30%, so the company’s profits are suffering. P&G’s big competitors have followed the company’s price reduction initiatives so financial analysts are now questioning the wisdom of P&G’s move to reduce prices. One analyst notes that if everyone follows P&G’s price cuts, then no one will be able to maintain profit margins.

The analyst misses the real effect of price reductions and the importance of P&G’s undertaking them today. When research indicates that consumers see little or no benefit to the more expensive over the less expensive products, all branded products in the category have gotten a severe warning shot across their bows. They have to beat back the low-end competitors, especially private label producers. The real enemy for the branded companies is not one another. (See the Perspective, “The Price Segment” on StrategyStreet.com.) The followers among the branded companies will gladly follow the industry leader as the leader raises prices. But they will howl when the leader reduces prices.

The price reductions hurt the near term profits of the branded producers, but they help the long term profits. How can this be? Because the price reductions cause severe margin squeezes and intense suffering among the private label producers. These producers must institute a commensurate price reduction, even though they don’t have the margin structure to sustain such a price reduction. The low-end competitors are then in a double bind. Their prices are falling at the same time that they are losing volume. These low-end competitors, in turn, will cheapen their product and their support for retailers and consumers. As these low-end competitors recede from their positions of relative strength, the leading, branded, companies are able to re-assert their pricing power and gain the benefits of higher prices on higher market shares.

A Pricing Scheme Guaranteed to Fail

2010-10-04T16:42:00.000-07:00

There is a new gift card brokerage product coming to the online market. It’s called CardWoo.com. This company buys your unwanted gift cards at a discount. You mail in your card and they will send you a check for it. The amount of the check, as a percentage of the card value, is not stated in their online information. You, then, have fourteen days to decide whether to accept the check or send it back and get your gift card back.

The problem comes on the other side of the deal. CardWoo then takes the cards it buys and resells them online. The problem is their discount. Most of these cards have face values of $10 to $75. The majority seem to fall in the $25 to $50 range. The discounts CardWoo offers the purchaser of the card range anywhere from 0% (why would anyone do that?) to 5%. 5% of $50, the higher end of most of the cards, comes to all of $2.50. This discount is far too small to really attract many customers. (See “Audio Tip #143: Offensive Pricing Guidelines” on StrategyStreet.com.)

We have looked at more than 800 examples of discounted products. The median discount offered in a marketplace is 25%. 75% of discounts are 10% or more. CardWoo’s discounts are far too low to attract a mass audience. (See “Audio Tip #137: Price Shavers and Their Pricng” on StrategyStreet.com.)

The Kindle as a Razor

2010-09-30T15:03:00.000-07:00

Amazon is proving to be a stubborn competitor. Many people thought Amazon would be severely damaged by the market entrance of the Apple iPad. After all, the iPad does many more things than simply provide an eBook reading experience. But, the Kindle is not going away easily. The company claims that it appeals to “serious readers,” which it estimates at about 10% of the population, and Amazon is chasing that 10% avidly.

Amazon is using the Kindle as a Loss Leader. Recently, a company estimated that the cost of the Kindle, that is all its parts and labor, was about $185. Amazon claims that the cost is much higher. This cost was not a great deal of the problem when the Kindle2 sold for $400, about its introductory price. Nor was it a problem when the Kindle sold for $289, the cost of the second version. Now, the new and improved Kindle3 has a price as low as $139, well below the estimated $185 cost. Amazon is taking a significant haircut on the cost of the Kindle in order to populate future customers for its eBooks. The company makes an attractive profit on its eBook sales and uses the Kindle as the razor to its eBook razorblades.

Amazon has also hedged its bet. Kindle eBooks also are readable on the iPad, so we are about to see an interesting contest between a very inexpensive Kindle and the iPad for the eyes of future eBook readers.

This razor and razorblade strategy is common (see StrategyStreet.com/Improve/Pricing/Reduce Prices). Here are some of the other places it has taken place:

* Caterpillar often reduced prices on new equipment in order to assure itself of the replacement parts business.

* The Palm Trio 600 had a list price of $600, but a consumer could buy it for as little as $330 with a phone service contract.

* Nintendo subsidized the sale of its game consoles in order to boost the sales of its game software.

* Restaurants offer free, or inexpensive, appetizers at the bar in order to increase alcohol sales.

* Charles Schwab offered a $400 analysis of a client’s holdings, including two hours worth of in-person advice, in order to increase the odds that it would be able to manage the client’s money for a yearly fee.

These Loss Leader pricing innovations are worthwhile whenever the revenues from the attendant products, which follow the Loss Leader product, are worth considerably more than is the Loss Leader.

Apple's Future in Smart Phones - Part II

2010-09-27T15:24:00.000-07:00

Apple is the clear leader in today’s consumer smart phone market. Research in Motion leads the commercial market. I am going to make the case that a few years from now, they will have a single digit market share. They will turn into a Performance Leader, a small high-priced competitor in the market. (See “Video #24: Price Point Specialists in Hostility” on StrategyStreet.com.) This position will be similar to the one Apple holds today in the personal computer market. In Part I of this blog, we described the evolution of Apple in the personal computer market. Apple today produces a marvelous personal computer. It appears that Apple is following the same map in the smart phone market as it followed in personal computers.

Apple owns both the hardware and the software in its smart phones. And it keeps both exclusive to Apple. It had early mover advantage so it garnered virtually all of the apps that people cared to develop for its smart phone platform. But a new competitor has emerged in the Android operating system. Android fills the same role as Microsoft did in the personal computer industry. Microsoft was cheap and available for many hardware platforms. The PC attracted the most app developers. Android is cheap and attractive to app developers. On the other hand, Apple has made life difficult for app developers by forcing them to jump through hoops in order to gain approval to offer apps on the Apple iPhone platform. Today, Apple has something north of 200,000 apps. Android has 70,000 apps. But, as one analyst noted, every app that a number of people are likely to want to use today is already available for both the Android and the iTouch. Apple may have more apps, but most of the apps exclusive to Apple appeal to narrow niches.

Now let’s play forward the next few years. (See “Audio Tip #32: Introduction to Step 7 of the Basic Strategy Guide” on StrategyStreet.com.) Motorola, HTC, LG and Samsung are among the many companies producing Android-based phones. The Android market is growing quickly. It will grow even more quickly as the prices of the Android handsets fall under the pressure of competition in the smart phone hardware market among some big, capable companies. Within a year, the app developers will write new apps, first for the Android platform and second for the Apple iPhone or other smart phone platform. Several years from now, the intense competition in the hardware market will reduce the cost of an Android smart phone low enough to remove a good deal of the profit that Apple now enjoys with the iPhone. (See “Audio Tip #102: When is Price Likely to Go Down?” on StrategyStreet.com.) As the Android smart phone producers continually add the features and capability to make their phones unique for consumers, the Android phones will be nearly as capable as, if not the equal of, the Apple iPhone. And, the Android phones will be much cheaper. Apple will be pushed into a Performance Leader position, where it offers high-priced feature-rich phones and garners a share of the market likely to be in single digits. This will not happen overnight. The smart phone market is still in its infancy. But check back in three to four years.

It will be interesting to see whether this competitive pattern holds in the tablet computer market as well.

Apple's Future in Smart Phones - Part I

2010-09-23T11:14:00.000-07:00

Apple is the clear leader in today’s consumer smart phone market. Research in Motion leads the commercial market. I am going to make the case that a few years from now, they will have a single digit market share. They will turn into a Performance Leader, a small high-priced competitor in the market. This position will be similar to the one Apple holds today in the personal computer market. It appears that Apple is following the same pathway it followed in the personal computer market. Perhaps a bit of history is helpful here.

The business model of Apple differed from that of the PC. Apple was not the first personal computer, but it was, by far, the best. And, it got paid for being the best. Apple really created the mass market for personal computers. It had a huge percentage of the marketplace by the time 1981 rolled around and IBM introduced the PC. Apple controlled both the hardware and the software for its personal computer products. On the PC side, Microsoft’s Windows controlled the software, while a large number of companies became hardware producers for the Windows operating system. In the early years of the personal computer, the hardware was far more expensive than the software.

The PC market had a great deal more competition…and cost/price reductions. Apple prevented any other hardware producer from copying its products. There was at least one company who tried, Franklin Computer. But Apple killed them off in the mid-1980s. From that point on, there were no clone producers of Apple machines. The picture was very different on the IBM/Microsoft side. IBM found itself facing many competitors. Most of those competitors we called “clones.” Dell was one of those clones. This large number of hardware competitors reduced the cost of hardware drastically during the late 80s and through the 90s. (See “Audio Tip #196: Why Economies of Scales Exist” on StrategyStreet.com.) The source of much of the cost of the hardware for a personal computer shifted to the Intel or AMD chips embedded in the hardware. Still, AMD constantly challenged Intel, so Intel had to reduce its prices in order to maintain its very high market shares in chips. All of this intense competition reduced the cost of hardware until today the software costs as much as the hardware. Competition forced hardware components and prices down to such an extent that the PC platform had significant price advantages over the Macintosh/Apple platform. Apple was pushed into a high-cost/high-priced hardware position.

The competition in software was much less pronounced. It has only been in the last few years that Microsoft has had to respond to lower cost competition from Linux and Google. These lower cost competitors have had an impact on Microsoft’s prices, but nothing like the impact that the hardware competition had in reducing the price of hardware. The mass market followed the lower priced PC market. Apple today produces a marvelous machine. It has rabid and loyal fans. It also has high prices and a single digit share of the personal computer market. Were it not for the genius of Steve Jobs and his cohorts at Apple inventing new products with higher margins, Apple would be struggling today, much as it was before Steve Jobs returned to the company. It wouldn’t make a lot of money in the personal computer industry because the industry Standard Leaders, the PC producers, are so cost effective, and so much lower in price, than is Apple.

In Part II, we will see how this same pattern is playing out in the smart phone market.

Discounts - Much Greater Than Most Assume

2010-09-16T16:01:00.000-07:00

Recently, we did an extensive analysis of various forms of price reductions and discounts. In particular, we were interested in seeing how big discounts tended to be. Across roughly 850 instances of discounts, we found that the median discount was 25%. 75% of all discounts were 10% or greater.

Discounts in distressed markets are often much higher. Numerous examples reside in Florida condominiums. This market grew far too fast for demand and then collapsed quickly. Retail prices for condominiums there have fallen from 30% to 40% off their peak prices. If you are a big buyer, one capable of doing a bulk purchase, discounts are even larger. In one example, a condominium project had a cost of $340 per square foot to build. The complex had 375 luxury units which sat in bankruptcy. A developer bought 165 units at an auction sale at a price of $126 a square foot. That works out to a 63% discount on the cost of new building. (See StrategyStreet.com/Improve/Pricing/Reduce Price)

For comparison purposes, the median customer who is able to purchase a large package of a product buys that product at a discount of about 30% off of the retail price. 75% of these types of purchases have discount equal to or greater than 20%.

Service Levels Go Up, Not Down, in Hostility

2010-09-14T11:40:00.000-07:00

A market in overcapacity is hostile. Surprisingly, in a hostile market service levels to customers go up, not down. (See “Video #36: Probable Priorities for Innovation in Hostile Markets” on StrategyStreet.com.) The airline industry is an example. The airline industry has been hostile virtually from the day it was deregulated in 1978 until today. During that time, the industry has made great strides in reducing its costs and increasing its service levels at the same time.

Here are some interesting statistics that bear out this contention. These statistics compare the airline industry in 1969 to that of 2009. In 1969, 172 million passengers flew U.S. Airlines. By 2009, that number had grown to 770 million. In 1969, there were 5.4 million flights. By 2009, the flight numbers had risen to 10.1 million. Service levels, as measured by number of flights and number of passengers, clearly have risen over the last forty years. During that time, safety clearly improved. Fatal accidents per 100,000 departures were 1.3 in 1969 and .1 by 2009. Pricing dropped as well, because costs dropped. In 2009, it cost a passenger 14 cents to fly one mile. The comparable number in 1969, using 2009 dollars, was 34 cents. Today you can get to more places faster by airliner than you could in 1969. Service levels have risen.

Naturally, those of us who fly would complain that service levels in terms of comfort have fallen drastically. Meals used to be free and there used to be ample space for knees and luggage. Those days seem to have passed...or have they?

The airlines have learned time and again that customers will not pay for onboard meals and more leg room. However, those customers who are willing to pay for more comfort can fly in economy plus or business class or first class. The prices for these services today are much lower than they were several years ago. So no matter how you slice it, service levels have risen in the industry when you look at the service levels for which customers are willing to pay.

The same holds true in every hostile industry. (See “Video #37: Performance Innovation Tradeoffs in Hostility” on StrategyStreet.com.)

Pricing in the Dog Days of August

2010-09-09T13:51:00.000-07:00

It seems that not many people wanted to spend the weekend in Philadelphia during August. Hotels that might be full during the week were sparsely populated on the weekends. But, Marriott was not taking this situation lying down.

The Philadelphia Marriott came up with an innovative pricing strategy. Any guest who booked a two-night stay starting any Friday during August into mid-September had to pay only the price of the highest outside temperature for the Saturday night rate. So, the guest paid regular prices on Friday night and the heavily discounted rate, based on the day’s high temperature, for Saturday night. A clever approach to discounting.

This is one of several approaches companies have used to get through periodic, or seasonal slow demand times. Companies have used the components of a price in order to bring customers to its products during slow times. For example:

* A construction company changed its list price much as did the Philadelphia Marriott. It priced its services very aggressively for the months of January and February so its customers would move work forward that would normally be done in the spring or summer.

* Other companies change the definition of their product to reach a new, lower, price point. Companies who sell fractional ownerships of private jets offer discounts up to 25% for flying on off-peak days.

* Other companies make direct payments to customers. We can see this approach with the current Orbitz program called Price Assurance. Orbitz refunds customers the differences in fare if a customer purchases an airline ticket and then sees the price of the ticket fall before he leaves on his trip.

* Some sellers throw in a free, or heavily discounted, product from a third party. For example, as the housing market became more difficult, some sellers offered to outfit a media room or pay closing costs for their buyers.

We believe that a company facing a tough pricing environment can gain a lot by studying what other companies have done when facing the same circumstances. We have many of these examples on our web site. (See Improve/Pricing on StrategyStreet.com.)

Be Afraid. Be Very Afraid...Oh, Never Mind

2010-09-02T15:32:00.000-07:00

The 2010 American Customer Satisfaction Index E-Business Report is out. The report is the product of the research firm ForeSee Results. The research firm uses data provided by the University of Michigan. Analysts argue that the report should sound an alarm for Google and Facebook, two of the web’s most popular sites. Apparently, the companies are not doing as good a job as they have in the past with privacy policies and ease of use of their web sites. The report’s scores are set so that a score under 70 is considered poor. Facebook gets a rating of 64, despite the fact that it is the largest and fastest growing social networking service in the U.S. Google gets a rating of 80. This rating is down from 86 a year ago. What are we to make of this?
Not much.

If you went out today and purchased an automobile that had the styling, operating capabilities and characteristics of an automobile from 1960, you would be severely disappointed. You would compare that car to today’s car and find the older car sorely lacking. How, then, did anyone sell a car in 1960? They sold cars in 1960 because they didn’t have the automobiles of 2010 to compete with those cars. The relevant comparison is not an absolute measure. It is only a relative measure. We have to view Facebook and Google against their competition, not against an absolute standard. (See “Video #70: Overview of Products and Services Part 2: What to Expect” on StrategyStreet.com.)

When you look at these two companies against their closest competitors, they come out rather well. Facebook’s “dismal” 64 rating compares with its nearest rival, MySpace, with its rating of 63. Google’s “falling” rating of 80 compares with Microsoft’s Bing at 77 and Yahoo at 76. The sky is not falling. (See the Perspective, “How Customers Buy” on StrategyStreet.com.)

In any competitive market, the standard is not absolute performance, but relative performance. If a company’s relative performance begins to fall, it will lose market share and you can expect falling quality rankings to account for much of the market share loss. An absolute standard is meaningless. Perfection of performance has a cost well beyond what the vast majority of customers would be willing to pay.

Reliability in the Purchase Decision

2010-08-26T16:00:00.000-07:00

In our StrategyStreet analytical framework, a customer subjects a potential supplier to two levels of elimination: invitation and evaluation. With “invitation”, the customer decides who he will spend any time considering in the purchase decision. In “evaluation”, the customer eliminates potential suppliers on its most important purchasing criteria. Then, the customer analyzes the remaining potential suppliers in detail in order to make his final choice. At both levels, the customer is looking to eliminate suppliers, not to choose one. (See the Perspective, “The Tallest Dwarf” on StrategyStreet.com.) In the final analysis, most buying decisions are the result of the elimination of all other competitors, rather than the positive choice of one of them.

McKinsey & Company used a construct similar to our approach of “invitation” and “evaluation” when looking on consumer decisions in the mobile phone market. It considered three stages of the customer buying decision: initial consideration, active evaluation, and moment of purchase. McKinsey, then, looked at how consumers made their choices at each stage in mature markets and in developing markets. What we see in the McKinsey statistics is the paramount importance of Reliability in getting to serious consideration, even in a relatively fast-growing market like mobile phones. (See “Audio Tip #95: The Customer Buying Hierarchy” on StrategyStreet.com.) The three most important criteria in the initial consideration in a mature market were advertising, previous usage and word-of-mouth. Previous usage and word-of-mouth are indications of Reliability concerns. Advertising can be either Reliability or Convenience. It is Reliability when the consumer looks to advertising as a sign that someone is a serious, reliable competitor. It is Convenience when the purpose of the advertising is to let the consumer know that the company can provide the product. In a developing market, the top three criteria are the same in a somewhat different order. (See “Audio Tip #70: Several Rounds in Evaluation Failures” on StrategyStreet.com.)

The mobile phone market is fast-growing. Differences in Function are important differentiators among competitors in this market, more so than in very difficult, hostile markets. But if the company can not convince a customer that it is a reliable supplier, it will never get the chance to demonstrate its superior Functions.

Reliability is important in every market, even in one with very fast growth.

Reliability in High-End Cars

2010-08-19T16:23:00.000-07:00

Several years ago, BMW ran into a problem with its technologically advanced automobiles. It found that some customers were reluctant to buy their cars because the customers were concerned about the cost of maintaining products with such high technology. But BMW believed in its product and felt that the customer should believe equally. So, for more than the last ten years, BMW has offered free maintenance with its new cars. For four years, or 50,000 miles, a BMW customer will not pay for maintenance except for gas and tires. BMW continues to gain share and profitability in the North American market. (See “Audio Tip #160: How Do We Segment Customers by Emotional Needs?” on StrategyStreet.com.) Competitors have noticed.

Now, competition is beginning to offer free maintenance of its own. As always, the devil is in the details of “free maintenance.” The “Gold Standard” BMW covers everything but gas and tires. Competition offers “free” maintenance, but their version of free maintenance does not match BMW’s. Volvo’s “Safe + Secure Coverage Plan” covers five years or 60,000 miles, and includes oil and filter changes and replacement of brake pads and rotors and windshield wipers. Cadillac’s “Premium Care Maintenance” doesn’t cover brakes and is limited to scheduled oil changes, tire rotations, replacement of engine and cabin air filters and a multi-point vehicle inspection.

Other competitors cover what BMW covers, but charges for it. Audi sells a maintenance plan separately with the list price of about $790. Mercedes Benz offers prepaid service packages.

All of these competitors to BMW fall short of the mark. If you were a customer deciding on an automobile to buy, and you cared about the Reliability of the vehicle during the time you owned it, who would you trust more? On the one hand, you have the company that promises true “free maintenance.” On the other hand, you have competitors who qualify, or charge for, their promise of “free maintenance.” If you want to compete with the standard, you have to be at least as good as the standard. BMW still leads the pack in Reliability when it comes to “free maintenance.” (See “Video #14: Definition of Reliability” on StrategyStreet.com.)

The Decline of an Industry Leader

2010-08-16T16:29:00.000-07:00

In a tough, highly competitive market place, the avoidance of Failure and a company’s reputation for Reliability are critical to long term success. (See “Video #14: Definition of Reliability” on StrategyStreet.com.) Dell is an example.

For years, Dell was the paragon for the personal computer industry. It had good computers with a build-to-order business model that took in cash before the company had to pay suppliers. Its low-cost business model involved maintenance of low inventories and tight control of its suppliers. Then the wheels came off.

From 2003 to 2007, Dell shipped a number of its mainline personal computers with serious flaws. The facts have come out recently in court documents in a suit filed by a customer against Dell claiming that these faulty computers cost the customer a good deal of money. It seems this customer was not alone.

Dell’s problems showed up because a supplier shipped it bad capacitors. An Asian company, Nichicon, produced bad capacitors, which Dell included in its motherboards on nearly 12 million computers shipped to customers from May 2003 to July 2005. A study of these computers suggested that these capacitors would cause problems in Dell computers 97% of the time, if the computer were used over a three year period.

Dell did not handle this situation well. It placed cost control ahead of customer welfare. (See the Perspective, “Cutting the Right Cost” on StrategyStreet.com.) In some cases, it replaced bad motherboards with other bad motherboards. In other cases, customer service and sales employees went out of their way to conceal these problems. Dell told some of its customers that the customers were at fault for the failing computers because they had over taxed the machines. Nor did Dell recall the faulty computers. Instead, it left it up to the customer to make a complaint before it took action. In the meantime, customers suffered the costs of losing information when their computers failed to function properly. Dell failed its customers and ravaged its Reliability reputation.

Dell is no longer the paragon of the personal computer industry. That mantle now rests on the shoulders of HP and, perhaps, Acer. Dell’s market share has fallen off. In a tough marketplace, the Failure of an incumbent supplier is the cause of most market share shifts in the industry. If an incumbent Fails the customer by refusing to do something that other people can and will do, it will lose market share. Another critical aspect of a company operating in a very tough market is Reliability. The customer has to trust that the company’s products will work, and if they do not work, they will be fixed promptly. Dell at one time had a good Reliability reputation. It gained share on the back of that good reputation. The company has badly frayed that reputation and its failures have caused its loss of market share. (See “Audio Tip #36: The Importance of Customer Retention in Hostility” on StrategyStreet.com.) These failures account, in part, for the share gained of Hewlett Packard.

The Importance of Consistency in the Approach to Pricing

2010-08-12T14:28:00.000-07:00

A company has to send a consistent pricing message if it wants its customers to get its message. An example is Asda. Asda is the U.K. arm of Wal-Mart stores. Asda has always advertised itself as the home of “every day low prices.” It strayed from this message during the recession.

As the recession took hold, Asda followed its major competitors in offering promotional pricing, such as temporary price deals and two-for-one specials. (See the Perspective, “The Grasshopper and the Ant” on StrategyStreet.com.)

This approach worked during the recession. The company gained market share. However, as the recession ended, the company lost all of the market share it had gained with its promotional pricing. It then found that its customers were confused about what its pricing tactic really was. The company has re-established its theme of “every day low pricing.” In order to emphasize that theme, it has launched a price guarantee program which guarantees the consumer that its prices will be the lowest among its competitors, whether there is a promotion or not. The program invites the customers to check receipts online, and to obtain a rebate if a competitor is offering a better deal. (See the Perspective, “How Price Kills Profits” on StrategyStreet.com.)

It will take a while for consumers to have confidence in this renewed emphasis on every day low prices.

Pricing in Easy Industries

2010-08-09T13:48:00.000-07:00

Here is an example where relatively small differences in price, in normally easy industries, have a big effect in the market.

PepsiCo owns Lifewater. Over the last year, Lifewater’s sales have risen by 85%, while overall sales of bottled water have fallen by 5%. Coca-Cola owns a Lifewater competitor named Vitaminwater. During the same period, Vitaminwater saw its market share shrink.

PepsiCo has been paying more attention to Lifewater. It redesigned its bottle and introduced a no-calorie version of the drink. It also changed its advertising emphasis.

But pricing has certainly played a role in the marketplace. As the recession began to take hold, PepsiCo shaved four cents off the price of Lifewater (see “Audio Tip #106: How do we Predict Competitor Responses to our Price Moves?”), dropping it to an average of $1.18. Vitaminwater chose the opposite approach. It raised its prices by 4%. This produced a 7% swing in price difference between Vitaminwater and Lifewater. This price change meant Lifewater appealed better to both consumers and the channel of distribution. Lifewater used the lower price to increase its retail presence, especially with Target stores. This created greater Convenience for the Lifewater consumer. Overall, Lifewater’s market share increased by 1.6 share points to 3.8%. (See “Audio Tip #45: The Components of Positive Volatility” on StrategyStreet.com.) Vitaminwater’s share dropped from 14% to 11.4%. (See “Audio Tip #46: The Components of Negative Volatility” on StrategyStreet.com.)

Pricing and price differences are never irrelevant. Customers are loath to pay higher prices for products that otherwise seem Functionally comparable.

Situation Bad...About to Get Worse

2010-08-02T14:19:00.000-07:00

Over the last year, the U.S. government spent $80 million to prop up General Motors and Chrysler. The intent was to save millions of American manufacturing jobs. The benefits seem to be temporary, at best.

Both Chrysler and General Motors are reducing manufacturing capacity in the U.S. and shifting some of that capacity to Mexico. Over the next decade, Mexico is scheduled to gain most of the GM and Chrysler North American production that is discontinued in the United States. The reason isn’t hard to see. GM and Ford workers in the U.S. earn about $55 an hour, including benefits. The same workers in Mexico earn something less than $4 an hour.

Some in the government are upset about GM and Chrysler opening more facilities in Mexico, while U.S. facilities close. These people simply do not understand global economics. If GM and Chrysler keep their production in North America, all that will happen is that GM and Chrysler, backed by the U.S. tax payers and current shareholders, will pay for the excess wages that the domestic UAW employees now earn. If GM and Chrysler do not move their production facilities to places where costs are lower, other companies will do it for them and take their market share with better cars and lower prices. This has been the scenario for the domestic automobile manufacturers for the last twenty years.

No matter what the U.S. members of the UAW choose to do, their future is going to get worse. (See the Symptom & Implication “Foreign competitors are expanding with low prices” on StrategyStreet.com) Workers in other countries can simply make automobiles cheaper than they can. Chennai, India is a good example. In 2010, this city will produce 1.5 million automobiles. That is well in excess of 10% of the U.S. domestic demand and more than any U.S. state produces. Many major automobile manufacturers have a presence in Chennai.

The investment there is growing much as it is in Mexico. Hyundai, Ford and Nissan are each investing heavily in facilities in Chennai. Hyundai can now produce 650,000 cars a year there. Nissan can produce 400,000 cars annually. This new capacity is coming into a market that already has significant overcapacity in global production facilities. When new low-cost competitors enter the marketplace, they squeeze out the high-cost competitors. Who are the high-cost competitors? Watch where facilities are closing. Oh oh, that seems to be the U.S., where the UAW is holding a significant price/cost umbrella over its low-cost worker competitors, among whom are the Indian and Mexican workers in this story.

This will not have a pretty ending for the United Auto Workers, neither for those working nor for retirees.

Dis-Economies of Scale

2010-07-29T15:36:00.000-07:00

McKinsey research has found that only 10% of cost reduction programs sustain their results after three years. The problem seems to be overhead. Companies have exploited manufacturing efficiencies to reduce the cost of goods sold as a percentage of revenues by nearly 3% over the past decade. On the other hand, sales, general and administrative costs have remained about the same. The performance of sales, general and administrative SG&A costs is an example of dis-economies of scale.

A few definitions are in order. Economies of scale is the phenomenon where unit costs decline as the number of units sold increases. (See “Audio Tip #195: Economies of Scale and Their Measurement” on StrategyStreet.com) This happens because part of the cost structure is fixed, so it grows at a fraction of the rate of growth of the unit volume the company sells. Dis-economies of scale occur where units of costs increase at a rate that is greater than the increase in the units of output. (See “Audio Tip #198: Dis-Economies of Scale” on StrategyStreet.com) In other words, there appear to be no significant fixed costs in the company’s cost structure when dis-economies of scale occur. At the other end of the cost spectrum, you see super-economies of scale. Super-economies occur with costs decline, even as the number of units sold increases. (See “Audio Tip #199: Super-Economies of Scale” on StrategyStreet.com) Usually the super-economies occur due to changes in technology, when the company replaces many employees with technology capital investments.

Now let’s return to the problem of SG&A costs. In 1998, the SG&A costs for the S&P 500 companies were roughly 22% of sales. By 2008, SG&A costs still commanded 22% of the sales dollar. During those ten years, the physical units of output the S&P 500 companies produced certainly increased. On the other hand, the SG&A costs remained the same as a percentage of sales. Are none of the SG&A costs fixed? If there were some fixed costs in SG&A, the companies should have been able to increase the units sold without a proportional increase in numbers of people in the SG&A functions, creating economies of sale. But they did not produce economies of scale as measured as a percentage of revenue. What happened then? Either the number of people employed in the SG&A functions grew with unit sales or the companies paid the average SG&A employee at a higher rate than sales grew. In either case, you have dis-economies of scale operating in SG&A.

Over the years, we have been involved in many cost reduction efforts. We have seen that it is hard to sustain the results of a cost reduction effort over a long period of time. The McKinsey study serves as ample testimony to this fact. What may be helpful is to tie physical units of costs, for example numbers of full time equivalent employees, to physical measures of output, such as customer orders. If the ratio of physical units of cost to physical units of output goes down, the company has an excellent chance of creating economies of scale.

What Happens When Giants Rumble

2010-07-26T15:16:00.000-07:00

Over the last few years, Allstate Corporation, the big insurer of homes and automobiles, has concentrated its management efforts on producing industry-leading profitability. Profits have increased but the stock price has gone nowhere. And Allstate is losing market share.

Part of this market share loss is due to higher pricing than its key competitors. A look at market share changes suggests this fact. Both Geico and Progressive, who are known for aggressive pricing, have gained market share. (See the Symptom & Implication, “Large competitors are maintaining price levels as smaller competitors discount” on StrategyStreet.com.) Allstate’s market share has fallen, as have the shares of the smaller property and casualty insurers. The leader in the industry, State Farm, has gained market share.

Allstate is now altering course. The company’s top management has stated a goal to become the number one property and casualty insurer within the next ten years. At a minimum, this means Allstate’s market share must rise from today’s 10.5% in automobile insurance premiums to State Farm’s 18.6% market share, tough to do in a market growing only 3% a year. Allstate’s first priority is to stem the loss of current customers and then to find a way to develop programs that will enable them to gain market share. (See “Audio Tip #40: The Components of Market Share Change” on StrategyStreet.com.) A substantial part of these initiatives will involve more aggressive pricing.

This new pricing posture has begun to emerge. In Illinois, Allstate’s home state, the company recently offered a 5% discount to Geico customers who would switch to Allstate. In addition, the company is offering a one time bonus to customers who will agree to buy directly from its web site.

These are opening salvos in a price war. Price discounting begun by the second ranked competitor in the industry is going to effect every other competitor. Prices are going down, margins are going down and no one can avoid the battle. (See the Symptom & Implication, “As large competitors match low prices, other competitors face difficulties” on StrategyStreet.com.) As long as State Farm avoids the Leader’s Trap, the competitors who are likely to suffer most will be the industry’s smaller players. These companies will suffer mightily in a price war. They manage cost structures that do not enjoy the economies of scale of their much larger competitors.

These smaller competitors are likely to begin to fail in the marketplace. As they do, they may become acquisition candidates for Allstate. Acquisitions may, indeed, be a profitable route toward Allstate’s market share goal.

Finding a Home for Orphaned Products

2010-07-22T17:03:00.000-07:00

The pharmaceutical industry has taken steps in the last few years to reduce the cost of bringing a new drug to market. Pfizer has developed a novel approach.

We have analyzed several thousand cost reduction efforts. Each of these efforts, in one way or another, seeks to improve the productivity of costs by improving the amount of Output that a given quantity of Input can produce. We have found four basic approaches to improving this productivity: 1) reduce the rate of cost for the Input; 2) reduce Inputs not producing Output; 3) reduce unique activities in processes and products; and 4) spread fixed cost activities over new Output. (See StrategyStreet.com/Improve/Costs/Directions)

The pharmaceutical industry has used these approaches to reduce the cost and risk of developing new medications. For example, some companies have signed agreements with scientists overseas to develop new products (example #1 above). Others have used contract research organizations (example #1 above). Many have established joint ventures with competitors to spread the risk of developing new drugs (example #4 above).

Pfizer has developed a new organizational unit to use the second approach, reduce Inputs not producing Output. The company set this unit up in 2007 and named it Indications Discovery Unit. This organization enlists outsiders for help in finding uses for compounds that Pfizer had in development but that seemed to have no market potential. In a recent iteration, Pfizer agreed to pay $22.5 million over five years to researchers at the medical school of Washington University in St. Louis. Pfizer will give these researchers access to 500 molecules that otherwise would languish. These molecules were approved for a different use, were developed for a separate indication or they failed during testing for another use. This cost management innovation enables Pfizer to find new uses for work-in-process inventory that otherwise might have been written off.

A Win on Both Price and Convenience

2010-07-19T16:35:00.000-07:00

A few forward-thinking retailers have adopted predictive analytics in their loyalty programs. Among the few to use this tool today are Sam’s Club, CVS and Kroger. These programs offer both Convenience and Price advantages to individual customers. It is a true break-through innovation.

The Sam’s Club program provides a good illustration. Sam’s named this program eValues. This program offers bargains tailored to each Sam’s Club member. The member must be part of Sam’s Club “Plus” program. These “Plus” members may print out individually tailored eValues offers at a kiosk at the entrance to the store or by email or by visiting the Sam’s Club web site. Sam’s Club prepares these individualized offers by drawing on the purchasing history of the individual “Plus” members. Their purchasing history predicts what bargains and product combinations will attract the individual customer.

This eValues program is both a Convenience and a Price innovation. (See StrategyStreet.com/Diagnose/Products and Services/Customer Cost System) It is a Convenience innovation because it helps the customer find and choose products more quickly within the store. It is a Price innovation because it offers discounts on products the customer typically buys, or might buy. eValues is highly effective. The average coupon brings a response rate of 1% to 2%, but the eValues program results in customers getting the discount on 20% to 30% of the products where discounts are offered.

The stores’ loyalty programs become more relevant to their most important customers and the stores’ sales per customer visit increase. Clearly a win win situation.

Here We Go Again

2010-07-15T16:35:00.000-07:00

The leader of the United Auto Workers is retiring. He is leaving a union under siege. By 2009, UAW membership was about half of the level of 1995. The union has hemorrhaged members as the big three domestic automobile producers have shrunk in market share, lost billions of dollars, and closed plants.

The departing leader of the UAW claims that the industry’s difficulties never rested with the union and its rich contracts. In his view, the crisis that led to the bankruptcies of GM and Chrysler and the near bankruptcy of Ford was strictly the result of an unexpected spike in gas prices and a recession that resulted from the mortgage crisis. He believes that the fault lay not with the union and not with the industry. Following this belief, he is encouraging his successor to begin clawing back the cost-cutting concessions that the union has granted the Detroit big three domestic automobile manufacturers now that these companies are moving toward profitable operations.

The problem is that these concessions did not do enough, at least from the results they seem to have produced. The concessions really got underway in 2003, as the union reduced its wages and benefits and transferred retiree healthcare costs from the automakers to an independent trust. Despite these concessions, union membership fell parabolically from 2003 to 2009, right along with the profits in the big three. In the meantime, German and Asian manufacturers continued to be profitable. These profits included profits in U.S. domestic manufacturing facilities as well. (See the Symptom & Implication, “Some industry leaders have lower returns than the smaller competitors” on StrategyStreet.com.)

The union is heading back to trouble and will take its unionized facilities with them. In an earlier blog (See Blog HERE), we described the hourly cost differences in wage rates between a unionized and non-unionized domestic facility. These cost differences are unsustainable in the longer term. No one can expect that an automobile plant with $73 dollar an hour labor will be profitable enough to compete with another domestic plant producing similar automobiles at $48 an hour. Despite recent troubles, the Asian manufacturers still command a premium price over their big three competitors for their products. So, Toyota and Honda get a higher price and produce with a lower costs. (See “Video #1: The Two Best Consultants in the World” on StrategyStreet.com.) Tell me how GM, Chrysler and Ford can produce an equivalent or better car with these economic conditions. The claw-backs will only make things worse.

Defending the Low Cost Position

2010-07-12T16:31:00.000-07:00

The last couple of years have been very tough on the hotel industry. Now, some of the mainline hotel companies are starting to recover, but the high-end hotels continue their prolonged suffering. A typical example are the Four Seasons hotels. Last year the occupancy rate at the chain’s hotels was below 60% and revenue per available room, a key measure of sales, fell 26%. There are 82 Four Seasons hotels. At least 12 of them reputedly are near the breaking point.

The Four Seasons Company no longer owns any of its 82 branded hotels. It, like most of the hotel chains, sold off its hotels in the 80s to companies and investors who had more willingness and ability to carry high levels of leverage on the hotel properties. The Four Seasons, and most other hotel chains today, manage their brands but don’t own them.

The hotel brands tightly control the quality of their hotels through their management agreements. The management company receives a management fee of a percentage of the branded hotels’ revenues and also gets a percentage of the hotels’ profits. The hotel investor gets the use of the brand name and must conform to the rules as written in the management agreements. This arrangement allows for a disconnect between the interest of the hotel property owners and the hotel brand owners. The property owners may wish to find cost shortcuts that the brand owners abhor because the cost savings sully the brand name.

The founder of Four Seasons Hotels & Resorts watches carefully over the brand he created. Isadore Sharp is the founder and Chief Executive of Four Seasons Hotels & Resorts. He started with his first hotel in 1961. He built the company into the chain it is today by providing top notch service to its affluent guests. In the past, the company has weathered market downturns as relatively minor bumps in the road. This downturn has proven to be different. In this downturn, several property owners have petitioned the brand management company to reduce costs, sometimes at the guests’ expense. (See the Symptom & Implication, “The industry is reducing costs aggressively” on StrategyStreet.com.) Mr. Sharp will have little of it.

Mr. Sharp, who remains CEO of the company and 10% owner of Four Seasons Hotels & Resorts, agreed to some cost savings that have relatively little impact on the guest. Hotels may now outsource their laundry. They may simplify menus in the restaurants and even close a restaurant on slow nights on those hotels that have multiple restaurants. Some hotels may discontinue stocking fresh flowers in the lobbies as long as they replace those fresh flowers with sculptures or ornate vases. The property owners may also combine management positions and cross-train employees to work in multiple departments. Mr. Sharp believes that a guest will not see these kinds of cost savings in their visits to a Four Seasons Hotel.

But he refuses to go along with other cuts proposed by some property owners. The property owners may not combine the concierge desk with the check-in duties on the graveyard shift. Mr. Sharp insists that hotel employees continue to turn down guest bed covers each evening. He also refused a request to end room service during the middle of the night. All of these changes a guest would notice. (See “Video #46: The Place of Cost Management in Hostility” on StrategyStreet.com.)

These decisions by Mr. Sharp tell us a lot about why he has been so successful in his career. He keeps his attention focused on the quality of his guest experience, despite the short-term cost of continuing that form of Reliability. Profits may dip in the near-term, but he believes they will hold up in the long-term as customers return for the consistent quality of high level services they associate with the Four Seasons brand.

Mr. Sharp is protecting the ultimate low-cost position. We have found in our work and research in many industries that the low-cost position in a market is the ownership of a satisfied customer relationship. A company that owns a satisfied customer will not lose that customer to any other competitor unless that competitor can offer a similar product at a discount that begins at 15% and usually is more. We have not seen any market where peer competitors have cost structures that vary from one another by as much as 15%. Hence, the ownership of a satisfied customer relationship is the equivalent of having a 15% of revenue cost advantage on your peer competitors.

Mobile Hears Big Footsteps

2010-07-08T16:19:00.000-07:00

A short while ago, we wrote a blog about Radio Shack’s rebranding itself (See Blog HERE) as primarily a mobile product carrier. At the time, we predicted that Radio Shack would have a difficult time competing on Function with Best Buy. Though, it would be more Convenient than the average Best Buy. (See “Video #26: Example of the Customer Buying Hierarchy at Work” on StrategyStreet.com.)

Best Buy is ramping up its mobile product investment now. The company has created 80 stand-alone mobile stores from a standing start in 2006. It may add as many as 100 new shops this year. In addition to these stand-alone shops, BestBuy Mobile operates as a separate store within all 1,000 of Best Buy full-sized stores.

The company has set itself up to be able to catch the mobile wave without committing itself to high costs over the long term. The BestBuy Mobile stand-alone stores average 1500 square feet of footprint. The stores within the regular Best Buy stores are only 600 square feet. These stores compare with an average of 40,000 square feet for a regular Best Buy store. (See “Audio Tip #188: The Efficiency of the Input” on StrategyStreet.com.) The small footprint allows the company to offer fast-growing products in Convenient mall locations near consumers, especially women consumers. In a few years, when growth slows, the company can withdraw from these small locations at relatively little cost and fold the mobile business back into its large regular stores.

BestBuy Mobile looks to be the Function leader in this market. It offers ninety different handsets and service plans from nine carriers. They offer products that work on the networks run by all four major wireless carriers: AT&T, Verizon Wireless, Sprint Nextel and T-Mobile USA.

BestBuy Mobile offers clear advantages over the stores run by the wireless carriers. Their prices are lower. Pricing is also clear and easy, with no mail-in rebates. And the company promises that the customer will leave the store knowing exactly how to use their phone in what the company brands as its “Walk Out Working” product promise. This promise is both a Reliability and Convenience benefit.

Everyone else in the industry must be hearing Best Buy’s big footsteps.

How to Fail in a Market You Dominate

2010-07-06T15:43:00.000-07:00

The cable T.V. companies are the big dogs in the television industry. So far, no one has been able to unseat them, though they seem to be trying to unseat themselves. The cable industry is losing customers to satellite T.V. and phone companies entering the video market. The rate of these customer losses is significant.

In 2006, the cable T.V. companies controlled nearly 69 million video customers. By 2009, that number had fallen to 63 million. (See the Symptom & Implication, “The industry leaders are losing share” on StrategyStreet.com.) The problem is both price and service. Many consumers see these cable T.V. companies failing on both Price and Reliability. (See “Video #14: Definition of Reliability” on StrategyStreet.com.)

The cable T.V. companies have responded to the incursions of satellite and phone companies with discounts. Most of these discounts come in the form of bundles of products, including two or three choices among T.V., internet and telephone. Some of the discounts came in the form of free services during a promotional period. Still, the prices for cable T.V. have gone up every year faster than inflation. The discounts slowed, but did not stop, customer defections. Customers felt gouged.

A more troubling failure has come with customer service. We have all heard that power corrupts. Well, the cable T.V. companies had great market power for a long period of time. That power didn’t corrupt them in the moral sense, but certainly caused them to ignore the common tenets of good customer service. They offered service on their terms. Customers could take it or lump it. And customers became resentful.

Of the two failures, one of high prices and the other of Reliability failures with poor customer service, the most troubling is the Reliability failure. People tend not to forget and forgive Reliability failures for a long period of time. General Motors will be living down its reputation for less than stellar automobile quality for a long time. The same fate awaits the cable T.V. companies. (See “Audio Tip #35: How Does a Company "Fail" in a Market?” on StrategyStreet.com.)

More Steel Capacity. Why?

2010-06-17T15:08:00.000-07:00

China’s Anshan Iron and Steel Group has announced plans to invest in up to five new steel mills along with a U.S. domestic partner. The last time I looked, the U.S. was swimming in excess steel capacity. So why would this company enter the U.S. to add to an already over-supplied market? This is a political decision, not an economic one. Though, politics will obviously translate into dollars and cents eventually.

Anshan is partnering with Steel Development Company, a U.S. corporation, to invest $175 million in an initial “micro-mill” in Mississippi. Despite its cost, this is really a small investment. (See “Audio Tip #196: Why Economies of Scale Exist” on StrategyStreet.com.) The capacity of the mill is 300,000 metric tons. This mill will make reinforced metal bar. It adds relatively little to total capacity. The U.S. rebar market has 8 to 10 million short tons of capacity in the U.S. Nor does the new capacity add much to Anshan’s total capacity. Its total capacity in China totals 25 million metric tons.

This is a political investment. The U.S. government is under pressure from U.S. steelworkers. They charge that China competes unfairly in the steel industry. This investment is a partial response to that political problem.

We’ve seen this before. In the 1970s, I worked on a study to determine where a major Japanese electronics manufacturer should establish its first U.S. manufacturing facility. That new U.S. facility was not going to be a lower cost facility than those the company already had in Japan. But it would short-circuit arguments that the Japanese company was dumping its electronic products on the U.S. market. The Japanese automobile manufacturers, notably Honda and Toyota, did the same thing at roughly the same time. Over time, the Japanese auto plants were able to supply the domestic market economically. The domestic plants of the Japanese automakers, of course, have been operating under the cost umbrella held up by the United Autoworkers’ union wage rates and work rules. The U.S. steel industry has a lower union cost umbrella, so we are unlikely to see big foreign investments bringing a lot of new capacity to the U.S. steel industry. That is, we won’t see much more than is needed for political expediency. (See the Perspective, “Must the Cycle Start Again?” on StrategyStreet.com.)

No Red Letter Day for BlueStar

2010-06-14T15:08:00.000-07:00

Illinois opened its electricity market for non-residential customers in 1999. In 2010, about 75% of the electric load for commercial and industrial customers is purchased through alternative suppliers. That deregulation was a big success.

The state then deregulated its residential market in 2002. Virtually no one paid attention. Now there is a competitor about to enter the residential market where few have dared venture in the last eight years. But this entry is virtually certain to fail. BlueStar Energy is an alternative electricity supplier based in Chicago. This company is offering twelve month contracts that would lock in prices for consumers and save them an average of $6 to $7 per month over what those consumers would have paid to Commonwealth Edison.

We have to translate these $6 to $7 a month savings into percentages in order to have any perspective on the company’s prospects for success. These savings amount to an 8% to 9% savings for the consumer. This is not nearly enough to attract many new consumers.

We maintain a database of several hundred price reductions done over the last twenty-five years. These price reductions will vary according to the discounters’ objectives, target segments and with the components of price conveying for the discount. There is a strong warning for BlueStar in this price data. Their discount is not enough. Across our entire database of price reductions, the median discount is 25%, 75% of all discounts are 10% or more. That makes BlueStar’s 8% to 9% offering pretty sickly. (See StrategyStreet/Improve/Pricing/Reduce Price)

But the story gets worse if you are a low-end Price Leader as BlueStar is. BlueStar offers no advantage to the consumer other than price. That makes them a Price Leader. Price Leaders have to offer higher-than-average discounts in order to win significant market share. Low-end competitors have median discounts of 33%, 75% of them offer discounts of 20% or more to their customers.

Apparently, there are four other companies that Illinois has certified to supply residential electricity. They are waiting to see whether BlueStar is successful before entering. They won’t be coming. And BlueStar won’t be staying.

How to Become the Industry Leader

2010-06-10T15:24:00.000-07:00

Charles Schwab is the clear leader in the online brokerage world. While there have been hiccups in its development from a simple discount broker to a full-fledged online brokerage firm offering a range of products, the company has always maintained its leadership in the retail brokerage business. It focuses on the individual investor and, importantly, on investment advisors who manage retail customer accounts.

As the long time leader in the online brokerage industry, Schwab has emphasized the Customer Buying Hierarchy elements of Reliability and Convenience. Its advertising emphasizes Reliability, especially a personal caring relationship with its customers, for example, with its “talk to Chuck” advertising. The eponymous chairman and his company have consistently emphasized a relationship of trust between Schwab and the investor. (See the Perspective, “Reliability: The Hard Road to Sustainable Advantage” on StrategyStreet.com.)

Over the last few years, Schwab has entered many different product categories. As part of that effort, the company has recently introduced eight branded exchange-traded funds with very low cost management fees and commission-free trading. A couple of years ago, the company brought out a Visa credit card with no annual fee and a 2% cash-back feature. Its effort in entering these product categories has been to become a one-stop-shop for its customers. These are Convenience innovations. The customer has no need to leave Schwab to buy other products.

Schwab has been insightful in the way it manages its products and customer relationships. Two recent statements by Walter Bettinger, the current CEO of Charles Schwab, demonstrate the company’s commitment to Reliability and Convenience. In the first, the CEO acknowledges that the company may have to offer some products that have poor profitability in order to maintain a long term customer relationship. His observation: “We’ve never looked at product by product profitability as the answer to building a business.” A Standard Leader often has to measure profitability at the customer, rather than the product, level. (See the Perspective, “What We Do Know Can Hurt Us” on StrategyStreet.com.) The second statement is equally compelling and counter-intuitive in many companies. He observes: “Most companies are taken down, not by their competitors’ moves, but by their own.” In other words, industry leadership changes because the former leader fails, not because the new leader wins.

Can a High End Guy Hit the Mass Market?

2010-06-08T11:17:00.000-07:00

Starbucks is a high-end competitor in the fast food industry. We call these high-end competitors Performance Leaders (see “Audio Tip #82: Performance Leader Products and Companies” on StrategyStreet.com). As individuals, these Performance Leaders almost always have small market shares. Starbucks has 4% of the U.S. market for brewed coffee. As a group, Performance Leader market shares usually fall below 15% of a total market. Sometimes these Performance Leaders, following the allure of the volume in the mass market, create products to enter the mass market. We call the competitors who serve the mass market as their primary function Standard Leaders. Standard Leaders control the majority of most markets.

Starbucks has decided to enter the Standard Leader product category with its Seattle’s Best coffee. This coffee brand, and its coffee beans, sell today in Border’s Book Stores and many supermarkets. Starbucks wants to sell the product in fast food outlets, coffee houses and even in vending machines. By expanding the Seattle’s Best Coffee franchise, Starbucks hopes to land a blow to slow the invasion of McDonalds and Dunkin’ Donuts into the specialty coffee market. These latter firms are Standard Leaders who offer espresso-based coffee drinks at lower prices than Starbucks.

It is very common for a Standard Leader to enter the high-end Performance Leader product category with its own brand, as McDonalds and Dunkin’ Donuts has done. (See “Audio Tip #60: Customer Segmentation by Needs” on StrategyStreet.com.) The list of Standard Leaders who enter the Performance Leader product category is almost as long as the list of Standard Leaders. Think of Toyota and Lexus, Dell and Alienware Computers, Marriott and the Ritz Hotel chain, Gap and Banana Republic, among others. Many Standard Leaders discover, as their industries mature, that they must offer Performance Leader products, and sometimes low-end, Price Leader, products in order to offer a full line of products for their end users or channels of distribution.

It is much less common for a Performance Leader company to enter the Standard Leader product category, as Starbucks plans. This is a much tougher initiative. The Standard Leader category sells to much different consumers with different value propositions and significantly higher demands for economies of scale. Apple tried this Standard Leader entry several years ago and backed off in the face of withering competition from Windows-based computer makers. Some Performance Leaders have succeeded, at least to some extent. Harley-Davison offers the Buell motorcycle. Pella offers windows through large hardware and lumber stores. American Express has succeeded in offering a credit card. Years ago, Marriott, while still a Performance Leader, entered the Standard Leader price point with Courtyard and the Price Leader price point with Fairfield Inn.

It can be done, but it is a daunting task. Most Performance Leaders stay strictly Performance Leaders. For example, one company with some similarity to Starbucks is Samuel Adams. That company has yet to offer a Samuel Adams Standard Leader product.

What's Missing in Internet Retailing

2010-06-03T15:23:00.000-07:00

Every year I buy several things online. I don’t like to shop in stores because I usually need to buy only one thing. I hate to take the time to go to a store to buy just one item.

Online shopping, for me, beats bricks and mortar shopping on almost every dimension of the Customer Buying Hierarchy. (See “Video #17: Value and the Customer Buying Hierarchy” on StrategyStreet.com.) It has the advantage of Function. I can buy almost anything I want online. It has some advantages, though not all, over bricks and mortar in Reliability. When I shop online, I usually can find several web sites that will give me product reviews on exactly what I am trying to buy. Online shopping is more Convenient. I can sit at my desk to purchase, rather than going to a store and jostling with other equally impatient consumers. Online shopping is also more Convenient for me because I can easily check prices at a number of online outlets without having to visit them physically. So, online shopping also offers a Price advantage. I can usually get a lowest price guarantee when I shop online. That doesn’t necessarily mean that I will buy from the online site offering the lowest price, but I could if I wanted to do so.

I am sure I am not the only consumer who finds online shopping so advantageous. Web sales account for about 6.5% of total retail sales. That is a relatively small share, though it is growing. In 2009, total online sales increased by about 2%, while retail sales in bricks and mortar stores declined. So, online sales are growing market share in the retail sales industry. Why, though, doesn’t it have a higher share of total retail sales? Industry statistics lead me to think that the problem lies in a form of Reliability. (See the Perspective, “Customer Segmentation: Finding the Human Dimension” on StrategyStreet.com.)

The way people purchase today suggests that Reliability still remains a problem for online retailers. The top 500 web sites offering retail products grew 9% last year, considerably faster than total online sales at a 2% growth rate. However, the top 100 retail online sites grew 12%. Consumers clearly preferred the bigger online retail companies last year. Even more impressive, those companies that offer only online sales in the top 500 internet sales sites grew at 20% last year. Consumers are showing a strong preference for those online retailers who live and die with their online performance.

The online-only retailers tell the story of Amazon and the several thousand dwarves. Amazon has a 52% market share of the web-only online sales. The sales statistics and Amazon’s market power suggest that a form of Reliability is holding back the growth of internet retail sales. Consumers would like to know that they will receive the product that they ordered, that the product will work, that, if the product does not work, the retailer will stand behind it and that the retailer will guard the consumer’s credit card information carefully. Amazon has hurdled these barriers well and has reaped the rewards in growth and market share. All the other retailers selling online, especially those outside of the top 100, need to concentrate on creating assurances for their consumers that they can do as well as Amazon in these forms of Reliability.

Always Low Prices Meets Lower Prices

2010-06-01T14:09:00.000-07:00

Wal-Mart has come to dominate the grocery industry by offering wide product choices and low prices in their 2700 super centers. The company today is the biggest of the industry’s Standard Leaders. (See “Audio Tip #181: Using Physical Measures to Control Costs” on StrategyStreet.com.) And because the company has a well earned reputation for low prices, it found new customers during the last recession.

But underneath the new customer growth it found that some of their Core customers had migrated even further down on the food chain to discounting competitors, such as Save-A-Lot and Aldi stores. These companies offer even lower prices. They are able to offer these lower prices because they are Strippers. These are low-end, Price Leader (see “Audio Tip #83: Price Leader Products and Companies”), competitors who strip benefits from the product offering in order to achieve a low cost structure and consequent very low prices, which attract price-sensitive customers.

Save-A-Lot and Aldi compete with similar business models. They offer from 1400 to 1800 items, which is a small fraction of the offerings in a typical supermarket. The vast majority of their products are private labeled. The stores themselves are small, 15,000 to 17,000 square feet, and the store displays and amenities are spartan. Still, these retailers are growing relatively rapidly in the U.S. Wal-Mart feels like it needs to respond to their growth.

Wal-Mart does offer smaller stores. Their Neighborhood Markets concept are grocery stores in small towns and suburbs. But these are larger formats, averaging 42,000 square feet. The company’s small store format, called Marketside, has a 15,000 square foot footprint but has achieved relatively little presence so far. The Marketside business model has yet to develop any vibrancy.

Can Wal-Mart succeed at the very low end of the marketplace? I wouldn’t bet against them. They have succeeded in Mexico by offering seven separate store formats to meet the needs of consumers at various budget levels.

Coming Back from the Dead

2010-05-27T14:43:00.000-07:00

RadioShack Corporation has re-imagined itself as a major seller of smart phones. In an effort to get past its old and dowdy image, it has rebranded itself as “The Shack.” Today, it devotes about half of its relatively small stores’ shelf space to smart phones. It offers phones for most of the major carriers, as well as the Apple iPhone. This re-imaging seems to be helping the company. Its sales and stock price are on the rise.

Competition is getting tougher, however. The leader in electronic superstores, Best Buy, offers smart phones both in its main stores and in its fast-growing small stores, Best Buy Mobile, which sell only phones and phone equipment. Wal-Mart Stores is also a leader in electronics retailing. Wal-Mart is expanding into the fast-growing mobile phone business as well.

Let’s use the Customer Buying Hierarchy to guess at how this market might develop. Without a lot of deep research into the industry, I would guess that Best Buy will emerge as the Function leader. (See “Video #13: Definition of Function” on StrategyStreet.com.) It will offer more phones and more informed advice than will its competitors. The Shack is a Convenience player. They won’t have the Function choices of Best Buy but, with their 6500 locations, they will be a very Convenient buy for many consumers. (See “Video #15: Definition of Convenience” on StrategyStreet.com.) Wal-Mart’s strength will be both Convenience and Price. It offers Convenience in the sense that it offers smart phones, along with many other items that customers will buy much more frequently than they buy a smart phone. Primarily, Wal-Mart will offer low prices. (See “Video #10: Industry Consolidation and Recycling of Capacity” on StrategyStreet.com.) It is unlikely that anyone will compete seriously with them on pricing.

The smart phone market is a fast-growing market. Most of these markets see market shares shift due to Function and Price innovations. These are areas of real strength for Best Buy and Wal-Mart. Convenience will usually be a less important benefit in the movement of market share in these kinds of markets.

Convenience and Reliability Innovations in a Fast-Growing Market

2010-05-24T14:13:00.000-07:00

In a rapidly growing market, one growing faster than 15% a year in units, Function innovations tend to dominate market share movement. That is, Function innovations move more market share, on average, than do innovations in Reliability and Convenience. Often, the second major driver of market share movement in a fast-growing market is Price. Low prices and low-end competition often expand the market and cause significant market share shifts at the same time.

That is not to say that there aren’t Reliability and Convenience innovations. There are. The electronic reader market offers illustrations of these innovations. Barnes & Noble has an electronic reader called the Nook. This electronic reader is lagging in the market today, especially against the Amazon Kindle and the Apple iPad. To build awareness for its Nook product, Barnes & Noble has returned to T.V. advertising for the first time in several years. It wants to distinguish itself in the babble of noise from the many emerging eReaders and Tablets.

Advertising is both a Convenience and a Reliability innovation. It’s a Convenience innovation in that it helps the customer think of the product and know where to look for it. (See “Audio Tip #92: How Do We Add Knowledge to the Customer?” on StrategyStreet.com.) Advertising is also often a Reliability innovation because advertised products have stronger brand names and the aura of Reliability among consumers in a market. So advertising for Barnes & Noble should help the Nook gain some traction in the market. Will it be enough to overcome its laggard status? Probably not, due to its limited Function benefits in the form of attractive book titles. (See “Audio Tip #64: The Objectives of a Performance Improvement Program” on StrategyStreet.com.)

The leader in the market, Amazon’s Kindle, is also innovating its product in the form of Convenience. In the past, Amazon sold the Kindle only through its Amazon.com web site. This policy was in keeping with Amazon’s effort to get consumers of all products to purchase online, rather than through bricks-and-mortar retailers. Amazon has thought the better of this policy, though, with the advent of the Apple iPad. In part as a response to the availability of the iPad in Apple’s stores, Amazon has allowed Target to begin offering the Kindle at Target stores. Offering the product at Target is primarily a Convenience innovation. A customer can pick up the product faster at a Target store than by ordering online. In some ways, it is also a Reliability innovation. The customers can hold the product in their hands and see how the product works. Primarily, though, this is a Convenience innovation. Its main benefit for Amazon will be to prevent some loss of customer market share to a more Convenient iPad product. (See “Audio Tip #93: How Do We Reduce the Resources Used With Our Product?” on StrategyStreet.com.)

Hey, We Got New Features

2010-05-18T10:06:00.000-07:00

We have written several times about the Customer Buying Hierarchy. See some examples HERE, HERE, and HERE. This Hierarchy holds that customers buy Function, Reliability, Convenience and Price, and in that order. Most people assume that new Functions or Features drive a great deal of market share change. In most industries, this is not the case. In a Hostile industry, it is not the case at all. I recently read of two industries who stress Function innovation today. One will succeed with this kind of innovation. The other will have, at best, fleeting success with it. Function innovations work best, and are sometimes critical to the success of a company, in high-growth and stable high-profit industries. (See the Perspective, “When to Compete on Features” on StrategyStreet.com.) They are much less helpful in a very tough Hostile industry.

The TV broadcasting industry is stable and highly profitable. It has become somewhat more competitive over the last few years, as cheaper satellite broadcasters take share from the dominant cable TV firms. Innovation has kept prices high and stable. This industry caught a break a few years ago when high-definition television made its debut and caused sales of new televisions to soar. These soaring television sales pulled with them new high-definition channels and premium services offered by the television broadcasters. These were Function innovations. An industry leader had to offer them in order to stay competitive in the market.

Now the industry may have caught a break with another new technology, 3-D. Broadcasters, content providers and television manufacturers are all betting that 3-D will be the next big Function innovation in television. So far, DirectTV has taken the lead in offering 3-D content. This, again, is a Function innovation which should appeal to customers in a fast-growing market.

The hotel industry is Hostile today. The recession has taken the air out of the sales of hotel companies. In response to the fall-off in demand, the leading hotel companies are searching around for their next “new thing” to attract customers away from one another. Obviously, there is less demand to go around, so the only hope a company has to improve its revenues is to take customers from another competitor. Now the industry leading competitors are trying a Function innovation to take market share. This Function innovation is in bathrooms. Many hotels are investing in bathroom upgrades, including better hairdryers, new packaging of soaps and shampoos, larger and thicker towels and bathroom throw rugs, among other innovations.

These Function innovations in a Hostile marketplace will move very little market share. The reason is that virtually all competitors will copy the Function innovations as soon as it is clear that they appeal to customers. We have seen Function innovations fail before. Remember the more comfortable beds? How about the flat screen high-definition televisions? Or what about the new paint and decorations? Wifi in every room? All of these innovations had a very short period of uniqueness. Once hotel competitors saw they helped the top and bottom line, everyone copied them. Now they are all taken for granted.

Sometimes an industry turns Hostile when Function innovations can no longer produce lasting market share benefits. Then customers have to make their buying decision on Reliability, Convenience or Price. Reliability and Convenience are much more costly benefits on which to stake a company’s reputation with customers, so relatively few companies really invest to achieve superb Reliability and Convenience. That is why these benefits usually mark the industry winners in very tough markets. (See the Perspective, “Reliabiilty: The Hard Road to Sustainable Advantage” on StrategyStreet.com.)