Tuesday, August 16, 2011

Benefits of Intense Competition: Lower Prices and Better Products

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.

Friday, July 22, 2011

Does the Withdrawal of Capacity Help?

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

Wednesday, July 6, 2011

Failures in Reliability Lead to Share Loss

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.

Wednesday, June 29, 2011

The Mobile Phone Industry and Customer Retention

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

Wednesday, June 22, 2011

A Likely End Game to Hostility

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.

Wednesday, June 1, 2011

NestlĂ©’s Cost Reduction in the Coffee Business

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.