Is The Mojo Coming Back?

In early February, we did a blog on Abercrombie & Fitch and its Leader’s Trap (see blog Here). The company refused to lower its prices for fear of damaging its high-end, exclusive image. (See “Audio Tip #134: What are the Objectives of Our Pricing Policy?” on StrategyStreet.com.) The blog predicted that Abercrombie would have to lower its prices anyway.

In late May, we wrote a second blog on Abercrombie & Fitch and its Leader’s Trap (see blog Here). By then, the company had reported a first quarter loss and said that it would have to reduce its prices. We noted in that blog that companies who let their prices stay high for too long take a long time to recapture market share lost in a Leader’s Trap.

The story goes on. In the third quarter of 2009, Abercrombie same-store sales plunged 22%, the eighth consecutive period of sales declines. Profits dropped 39%. The company’s pricing, and some fashion slips, have cost the company dearly. The company has marked down items by 30% to 40%. It is also adding lower-priced clothing and some trendier styles in its stores.

The problem now is the company’s reputation for high prices. By falling into a Leader’s Trap, the company sent some erstwhile loyal customers to competitors such Aeropostale and American Eagle Outfitters. Many of these defecting customers have not come back yet. Some might never come back.

If prices are falling in a marketplace, even high-end, Performance Leader, competitors have to go along, or lose market share. For example, in the tough automobile industry, even BMW and Mercedes have had to offer price and financing incentives to keep sales going. (See “Audio Tip #142: Defensive Pricing Guidelines” on StrategyStreet.com.)

Make Them Wait

Three of the largest book publishers have decided to delay the release of their most popular new books to the e-Book market. This is unlikely to be a successful experiment. But another experiment from a fourth publisher offers promise.

E-Book readers, from Amazon, Barnes & Noble and Sony, among others, are some of this years hottest Christmas gifts. These e-Book readers are more than doubling last year’s unit sales. They are pulling the e-Book book sales with them.

The problem, of course, is money. An e-Book sells for about $10. The most popular hard cover books sell for $25 to $27. There’s the rub. The book publishers get about half of that $27 hard cover price. So you can imagine these publishers are less than excited about the opportunity in the retail price of an e-Book at $10, even if they would get all of that $10, which they won’t. (See “Audio Tip #88: Questions to Determine Your Response to a Low-end Competitor” on StrategyStreet.com.)

So, to try to hold the $27 hard cover market, three major publishing houses have announced delays in allowing their most popular titles to go to the electronic book publication market. HarperCollins Publishers, Hachette Book Group and Simon and Schuster plan to delay a few of the books that carry their highest expectations for profit. The delays will last from four to six months. These delays roughly match the time that the paperback version of a title follows the hard cover version.

On the one hand, these titles are unique Function innovations. Some readers will pay the higher price in order to be first in line to read the new publications. But there are many other unique books. The delays announced so far will cover less than 150 of the total 2000 new book titles issued each year.

The e-Book format is less costly and much more user-friendly. The e-Book is a much less expensive product to produce and deliver. Its digital format allows companies to distribute their product over the internet and to the e-Book readers by wireless connections. The e-Book reader can carry more than 1500 books. The user, then, can carry many books in the space of one paperback. This technology is not going to shrink nor pass away, no matter what publishers decide to do with their most popular new book titles. The cost of book publishing is simply going to plummet. But the revenues available to the industry over time should increase dramatically as new customers enter the market.

This e-Book market is an entirely new market. The e-Book offers opportunities to do things never before possible with hard cover books. The digital format allows companies to provide “special features” that enhance the attractiveness of the e-Book. These special features could include such benefits as interviews with the author, in-person video reviews by some of the country’s best book reviewers and videos of the geographic settings in the book, among others. There will be a lot of these new features (See “Audio Tip #29: Positive vs. Negative Volatility” on StrategyStreet.com). These new features, along with the much lower prices charged, will bring a whole new set of e-Book customers into the marketplace. Many of these new customers are not candidates for the $27 hard cover product. They will be happy buyers of the e-Book at $10 with its enhanced features.

A fourth member of the major book publishers, Macmillan, has developed a more creative and more promising approach. This approach envisions the release of an e-Book version of its best sellers on the same day as the hard cover book hits the shelves. The company envisions a “special edition” of the e-Book. This special edition will cost the same as the hard cover book and will be on the market for only 90 days. The special edition will include author interviews and reading guides, along with other material. At the end of 90 days, the special edition will discontinue and the company will issue the standard e-Book format at the lower standard e-Book price.

The publishing industry will fail at its delay experiment. They would be better off embracing the new technology, with its potential for extra Functions and ease-of-use, and then spending the next few years reducing the scale of the paper-based cost structure they carry today. My guess is that a hybrid version of the Macmillan experiment will eventually emerge. Under this hybrid version, all of the most popular books will be available in e-Book format, along with many function enhancements, like those in the Macmillan special edition, for a price a few dollars above the standard e-Book price, but at least 25% below the hard cover price. This approach ensures a much better value proposition for the e-Book customer, builds the e-Book market, and should allow the industry to make an attractive profit at the lower price, due to the much lower cost of production and distribution. Over time, the higher price of the most popular e-Books would gradually fall to the price of the standard e-Book in the market place so that the publisher may reap the rewards from customers willing to wait for a lower price on a good product.

Divorce that Customer?

Times are tough for business in many industries. Demand is off, prices are falling, and competition is fierce. Some companies have responded to these difficult conditions by divorcing their high-cost customers. Is this a good idea?

Perhaps this decision will increase profits. In a very tough market, it is not unusual for many customers to be “unprofitable.” (See the Perspective, “The New Pricing Structure” on StrategyStreet.com.) These customers may not produce a return on the company’s cost of capital through a business cycle at the industry’s current low prices. Pricing in the industry has fallen far enough that the price must discourage some of the industry’s capacity from producing. Several companies may find themselves pricing through “profitability levels” to maintain their relationship with a customer. This is more likely in an industry with low variable cash costs, such as most capital intensive industries. In these markets cash generation is more important than profits.

So, when should we divorce an “unprofitable” customer? The simple answer to that question is that you want to eliminate any customer who is not generating cash on sales to that customer. These customers are clearly unattractive in a tough market. They may also be unattractive in a better market. Certainly, today, they cost the business cash and are likely not worth keeping. (See “Video 63: Core Customers Part 1: Defining Core, Near and Non-Core Customers” on StategyStreet.com.)

There are two caveats to this rule. First, the company has to be sure that the reason the customer is unprofitable and, worse, failing to generate cash, is not that the company’s own cost structure is out of line with the competition. If the cost structure is out of line, that is higher than competition, then it must reduce its costs or get out of the business. (See the Perspective, “The Wisdom of Salomon” on StrategyStreet.com.) It is doomed to failure over time. The second caveat is that the customer is one who always pays low prices. The company should evaluate the customer relationship over the last few years, through a business cycle, to determine whether the customer is a perennial low-profit producer. If the customer is a low-profit producer through the business cycle, there is little risk in eliminating that customer. That customer does not generate enough money to support the capital his business demands.

Paying Attention to Low-End Competitors

When do we have to pay attention to low-end competitors? The cell phone operating system business gives us an indication.

There are a number of cell phone operating systems from which to choose. The major suppliers include Microsoft, Google, Apple, Nokia and Research in Motion. Google is the newest entry here, and is beginning to make waves with its free Android operating system. (See “Audio Tip #33: Strong vs. Weak Competitors” on StrategyStreet.com.)

There are two separate sets of customers for these operating systems. The first, and most important, are the carriers. The four major carriers include AT&T, Verizon, Sprint and TMobile. A secondary set of customers are the handset makers. These companies are secondary because they conform to the demands of the carriers in the U.S. These handset makers include Samsung, LG, Sony Ericsson, Kyocera, Dell, HTC and Apple.

In the cell phone operating system market, Nokia is the leader with its Symbian operating system. Research In Motion, with its operating system for its BlackBerrys, is also strong. The key growth market today is the smart phone market, where Apple has 13% of the market. Apple is gaining market share, at the expense of Windows Mobile, which has managed to hold on to 9% of the market. Google’s Android operating system is on only 2% of the world-wide smart phones. So should the operating system competitors fear Google’s Android? The answer is yes, for a couple of reasons.

The first, and most important, reason is that the largest carriers, all four of them, have agreed to offer Android phones. (See “Audio Tip #29: Positive vs. Negative Volatility” on StrategyStreet.com.) Whenever the largest customers in the market agree to carry a product, that product has to be taken seriously by other competitors. The adoption of Android systems by the top four carriers argues that Android is a serious competitor.

The next reason is that most of the phone set makers have also adopted an Android operating system for some of their phones. Motorola eliminated Windows Mobile in favor of Android. HTC plans for half of its phones to run on Android this year. And Dell is using Android for its market entry. Most of the other competitors, including Samsung, LG, Kyocera and Sony Ericsson are also making Android devices. Apple will not offer an Android phone. So, the secondary customers have also spoken and affirmed that Android is serious.

Once the major customers have endorsed a low-end competitor, that competitor’s impact on the market will be pervasive. Android will not be a low-end competitor for long. Google will use its growth in the market to fund product innovations which will bring its operating system up to the standards of the better players in the market. Further, the growth of the Android system, which is free, will inevitably reduce the volume of sales or the price, and probably both, of the higher end operating systems. A low-end competitor who continues offering low prices while, at the same time, improving its product’s performance will reduce the margins of all other competitors in the industry. Its performance for price proposition will focus customers’ attention on the marginal differences that the higher end operating systems offer for their marginal prices, depressing either sales or prices. (See “Audio Tip #80: Measuring Customer Cost Savings” on StrategyStreet.com.)

One Up, One Down, One Sideways

Three of the leaders of the automobile industry are presenting some interesting new stories. First, General Motors. The new Chairman of General Motors is Edward Whitacre. He is not a car guy. He came from the telecommunications industry, most recently as Chief Executive at AT&T. The Chairman recently asked the head of engineering at GM to call all the customers who had turned in their new cars under a recent quality program. This program offered customers a 60 day money-back guarantee. It allowed a customer who was unhappy with his automobile to turn it back to GM for a full refund. The head of the engineering group charged with calling the new customers noted that the focus on customer satisfaction was new at GM…and long overdue. This is a hopeful development for GM.

GM, for years, has had a poor reputation for reliability and durability. That problem seems slow to change, as witnessed by the recent quality survey by Consumer Reports. This survey criticized the company’s quality, finding it lower than the models from Ford, Honda and Toyota.

If the new top management attention to quality takes hold of the company, it is bound to improve its fortunes. It should move up with this development.

Fortunately for GM, its main competitor, Toyota, seems to be moving down, at least for now. Toyota became the leader in the automobile industry because of its reliability, but that reputation has begun to falter under the blows of recalls for rust problems and sudden acceleration in several models.

In a surprising upset, Hyundai Motors passed Toyota in J.D. Power & Associates survey measuring how many problems an automobile has in its first three months. A few years ago, Hyundai’s reputation for quality was equivalent to Madonna’s reputation for virginity. However, the Korean company instituted stringent measures to improve its quality, measures that seem to be paying great dividends today with their improved reputation and fast-growing market share. (See our blog on the quality changes at Hyundai HERE)

Ford seems to be moving sideways. On the one hand, its 2009 automobiles are getting good reviews from critics and the marketplace. The company is gaining market share. It also reported its first quarterly profit in four years. So, sideways, you ask? Yes, because Ford has a real problem with its cost structure. In October, the UAW refused to grant Ford the same contract terms that it had previously granted to Chrysler and General Motors. The most important part of the better terms that GM and Chrysler won was relief from the many work rules that restricted the work that an individual employee could do on the production line. These work rules make employees inefficient and idle. They reduce the company’s productivity. Not even Ford can face down a cost structure that is higher than those of its domestic and international competitors. Many of these competitors produce in non-unionized plants in the U.S., where work rules do not hinder productivity.

So, Ford is heading sideways until we see what it does to overcome this cost disadvantage. If the company follows the old GM approach of cheapening its fits, finishes and styling, it will lose market share and plunge into big losses. If, on the other hand, the company maintains the style and quality of its new cars, then it has a chance to address its longer term cost problems in ways that might be somewhat less disruptive to the UAW. (See the Perspective, “Achieving the Low Cost Position” on StrategyStreet.com.)

Ford’s situation is not promising. Many industry leaders, when faced with high and fixed labor costs in their industries, cheapen their products in order to eek out some profitability in the short-term. This always hurts them in the long-term. (See “Video #54: Cost Reduction by Winners vs. Losers in Hostility” on StrategyStreet.com.) The plight of the legacy airlines serves as an ample reminder of this tendency and its results.

Fewer Customers? Cut Capacity

For a year now the economy has weighed down passenger airline traffic. The industry expects a 4% reduction in passenger volume for 2009’s Thanksgiving season compared to the previous year. And, as demand has fallen, so have prices. Ticket prices this year are down 13% compared to 2008, so the industry is getting hit twice: by a fall-off in passenger seat miles flown, and by falling prices per seat mile. (See the Symptom & Implication “Demand in the industry is falling” on StrategyStreet.com.)

The airline industry thought it had an answer to this developing problem: cutting capacity. The industry has reduced capacity by 6.9% this year in the expectation that the industry could improve its efficiency and raise prices. (See “Audio Tip #116: The Withdrawal of Capacity to Raise Prices” on StrategyStreet.com.)

So, why haven’t prices risen? There are two possible answers. The first is that the industry has panicked and is offering lower prices to keep demand from falling any further than it already has. This answer is certainly in keeping with the industry’s previous practices. But there is a more subtle and more problematic answer as well, and that is that the smaller industry carriers are adding capacity faster than the industry leaders are reducing it.

Over the years we have witnessed many cases where industry leaders would reduce their capacity in order to constrain supply and force industry prices to rise. Time and again industry followers have stymied these initiatives. These followers insist on adding capacity, even as the industry leaders withdraw it. The result is the same, or more capacity, and continued low or falling prices.

To some extent, this addition of capacity by follower competitors is predictable (see “Audio Tip #106: How do we Predict Competitor Responses to our Price Moves?” on StrategyStreet.com). These smaller competitors already added capacity in the face of low industry pricing. They have even more incentive to add capacity as industry prices rise.

The Wrong Customer

CVS Caremark is struggling. The Caremark side, which is a pharmacy-benefit manager, is bleeding losses and major customers. The company picked the wrong customers.

CVS is one of the country’s premier retail drug store chains. The company has grown through acquisitions over the last several years. On the retail drugstore side, these acquisitions have been a great success. Not so, on the pharmacy benefit side. (See the Perspective, “Buying Share, Not Sand” on StrategyStreet.com.)

A couple of years ago, CVS beat out Express Scripts, a competing pharmacy-benefit manager, to win Caremark. The other competitors in pharmacy-benefit management are independent companies, focused strictly on the wholesaling of drugs to large companies and institutions.

CVS has trodden another path. As a retail druggist at heart, CVS developed innovations aimed at the retail, rather than the wholesale customer. For example, the company offers the Maintenance Choice plan that lets pharmacy-benefit management patients pick up 90 day prescriptions in its drug stores at the same low price they would pay through the mail. Of course, this helps CVS sell more products through its drug store chain. It does not, however, help the wholesale customer who makes the pharmacy-benefit management buying decision. (See “Video #34: Types of Product Innovations That Reduce Customer Costs” on StrategyStreet.com.) But there is even a downside for the retail customer, the employee of the wholesale customers. These retail customers must use a CVS drugstore to fill their prescriptions or see their drug co-pays rise to 50% rather than 25%. Hear loud protests off-stage.

Trouble started early in this acquisition. The wholesale customers have been unhappy for some time. In fact, last year CVS offered lower prices to more than half of its pharmacy-benefit management customers in order to keep them from defecting. A few other clients simply left,
discouraged by the fact that CVS seemed to be focused more on the retail, than on the wholesale, customers.

Of course, the Medco’s and Express Script’s are delighted to be picking up such easy share from the failures of CVS Caremark. (See “Audio Tip #35: How Does a Company “Fail” in a Market?” on StrategyStreet.com.)

Let Someone Else Pay the Freight

Some lucky companies have discovered ways to get other people to carry costs on their behalf. (See “Video #62: How to Improve a Cost Structure” on StrategyStreet.com.)

Twitter is a recent example. Twitter watches what its visitors do with its product and then has its engineers turn these ideas into new features. Twitter is about to release two new features, Lists and ReTweets, that began with users. With Lists, users can create lists of all the tweets written by celebrities or politicians. This innovation helps users save time in deciding whom to follow on Twitter. ReTweet allows a Twitter user to send a posting from another Twitter user to the user’s own set of followers. With these examples, Twitter has off-loaded some of the cost of R&D to its customers.

The shift of a company’s cost to others with no payment is not a new phenomenon. For example, as long ago as 1986, Walgreens decided to reduce its inventory levels by a third. It gave its suppliers the choice to participate in a just-in-time delivery program, or to stop supplying the company. Walgreens shifted the cost of inventory to its suppliers.

Customers can often do more than design new products. The Hilton Hotel chain installed computerized check-in kiosks in lobbies of its larger hotels in 2004. This allowed Hilton to reduce its check-in staffing. (See “Video #55: The Value of Customer Sensitive Cost Structures” on StrategyStreet.com.)

In the right situation, even the general public can help a company reduce its costs. One famous example is NetFlix. It offered a $1 million prize for new software that would predict more accurately whether a NetFlix customer would enjoy a movie based on the ratings of previous movies. A team of software developers won that prize in 2009.

We have found more than 50 examples of companies who shift costs to third parties for little or no payment. You can find them in the Improve/Costs section of StrategyStreet.

Microsoft is Leaving Money on the Table

Every few years, Microsoft introduces a new version of its very popular Office product. The last version was Office 2007. The next will be Office 2010. As often happens with technology upgrade innovations, the new versions sometimes do not offer enough additional benefits to justify all the customers of the old version spending on the upgrade. Office 2003 attracted 60% of the existing Office customers when it came out. Current expectations are for Office 2007 to attract somewhere between 50% and 55% of existing Office users to upgrade. So, somewhere between 40% and 45% of the current Microsoft Office market will not upgrade to the next version.

That is a problem for Microsoft. The company introduces its Office products in a bundled package. The product improvements and upgrades come in packages that contain most of the Office products, with the exception of the Access product. For the most part, Microsoft does not sell the improvements to the Office products as separate, stand-alone products.

Other companies have sensed an opportunity in this Microsoft approach. They have introduced add-on products that give old versions of Office some of the features of current and future Microsoft Office products without the full cost of upgrading. Some of these products include Xobni, DockVerse, Gist and Xiant. Basic versions of some of these products are free, while premium versions come at a modest cost.

These add-on products are low-end competitors. They are examples of Stripper products, one of the four major types of low-end competitors (see the Perspective “Turmoil Below: Confronting Low-End Competition” on StrategyStreet.com). Microsoft is ignoring the success of these small Stripper competitors.

It seems there should be a better path for Microsoft. The company might introduce its own stand-alone version of these products and match their pricing. This move would forestall the growth these Stripper companies enjoy today and provide Microsoft with additional revenues from the 40% of its current customer base who will not upgrade to the new Office 2010 product. If the customers like the Microsoft products as stand-alone add-ons, they may be more likely to upgrade to the new Office 2010 when it comes out.

Aside from the fact that Microsoft is leaving money on the table (see the Perspective “Failure Shifts Shifts More Share than Success” on StrategyStreet.com), it is generally a bad idea to ignore low-end competition that is entering your market.

Fish or Fowl?

The internet has given birth to another retail concept. A new set of retail start-ups specialize in discounted designer apparel. These web site based companies include Gilt.com, RueLaLa.com and HauteLook.com. These companies offer “private sales” to customers on a membership list. Each day the companies send an email offering “members only” sales on expensive designer goods. These goods are discounted heavily and are a year old, but these sites have been very popular. They are growing at a rate of over 20% a year. (See the Symptom & Implication “Small discounting competitors have gained a market toehold” on StrategyStreet.com.)

Now an industry leader is offering a challenge to these web-only discounters. Saks tested an online “private event” in October. This 36 hour sale invited customers, who received emails from Saks, to purchase designer goods at prices 50% below the suggested retail price. The company plans another similar online sale this month. The goods for sale are off season or specially made for the event.

The Saks model needs some significant tweaking before it can really compete with the “private sale” online discounters. First it has to establish a separate brand for this product. Not many designers are going to want to sell products through Saks at such significant discounts when their products sell at full price during the season. Customers can learn to simply wait for the “private sale” online event. As a corollary, Saks will have to do something to protect the brand name of the designer, perhaps by removing labels. A change in name and labeling would then enable Saks to use the “private sale” online events to liquidate excess inventory.

Since the online “private sale” discounters offer additional products daily, it is unlikely that the new Saks “private sale” online product will compete directly with the discounting on-line specialists (see “Audio Tip #17: The Heart of the Market” on StrategyStreet.com). The Saks initiative is much more likely to be an end-of-season service to benefit some of its loyal customers.

Digits Save Lives...and Costs by Improving Effectiveness

Part 2

Some hospitals, along with some health insurance companies, are using video technology to connect patients in outlying areas with specialists in urban centers. This video technology connects local and regional hospitals to large urban medical centers where most medical specialists practice medicine.

These video hook-ups provide information for both the specialist doctor and the patient. The specialist doctor has the benefit of a high definition video, both televisions and cameras, along with internet connected medical equipment and a nurse at the patient’s side to carry out instructions. The patient sees the specialist doctor on a video in the room.

The costs of these video systems have been declining. The typical system costs between $30,000 and $50,000. Thirty-five hundred hospitals now employ the system. These systems have a unit growth rate of 15% a year. They are about to become mainstream.

This innovation for both specialist doctors and patients offer us some good examples of cost reduction techniques.

We have examined several thousand examples of cost reduction efforts. There are four basic approaches to reducing costs:

*Reduce the rate of costs you pay for people, purchases and capital
*Reduce the costs that are not contributing to output because they are wasted or idle
*Redesign the product or the process to reduce components and activities
*Use fixed costs with more customers

The latter two of these four basic approaches to reducing costs improve the effectiveness of a cost structure by reducing the number of activities required for the completion of an Output. We call these activities Intermediate Cost Drivers (ICDs). (See “Audio Tip #189: The Effectiveness of the ICD” on StrategyStreet.com.) Effectiveness measures the ratio of ICDs to Output (ICD ÷ Output = Effectiveness).

A company improves the effectiveness of its cost structure by reducing activities, that is, ICDs. It reduces these activities by redesigning the product, or the process, the company uses to produce the product.

The company may redesign the product by reducing activities or components that make up the current product. The company may do this by reducing:

Performance standards which enables the company to eliminate activities
Components that are part of the current product

There are also several cost reduction alternatives available to the company who wishes to redesign the process to reduce activities. The company may use one of these recurring patterns of process cost reduction techniques:

- Shift the activity to others with no payment for their assistance
- Automate an activity
- Reduce the movement involved in the process
- Reduce errors the process produces
- Standardize activities
- Accept risk of lower revenues or higher costs
- Eliminate activities with low value to the customer

This new video technology improves Effectiveness with a redesign of the product. The video technology allows the patient to use an alternative form of a key component, the attending doctor. Since the specialist is at a distance, the patient does not receive the same quality of experience as he would if the specialist were physically present. The specialist doctor may be at a distance. But the specialist is more qualified than is any doctor at the patient’s location.

The process is more effective as well. The technology reduces the movement of patients. It substitutes the costs of the video technology for the costs of transportation by ambulance from the outlying locations to the urban centers. Perhaps more importantly, the process also reduces errors in the system by allowing an expert to diagnose the ailment and prescribe more immediate and more effective treatment.

The fourth basic approach to reducing cost improves a cost structure’s effectiveness by using fixed costs with more customers. These fixed costs, and their activities, become a lower proportion of the value of the final Output. (See “Audio Tip #196: Why Economies of Scale Exist” on StrategyStreet.com.) We have found two recurrent patterns to spread fixed costs activities over more customer Output:

- Acquire a similar organization and eliminate overlapping fixed costs
- Use the current fixed costs with new customer groups

The article on video technology did not offer an example of this fourth cost reduction approach. However, we can easily imagine how a hospital might employ this approach. First, the hospital system might acquire additional outlying locations and incorporate the video technology with these newly acquired hospitals as well. Alternatively, the hospital system, who already uses the video technology, might offer its technology to unrelated hospitals in similar locations near the company’s hospitals. The company would then benefit from the revenues these competing hospitals might provide and, in turn, use these revenues to reduce the effective costs it incurs for its video technology.

Of course, these are just a few of the cost reduction concepts we have observed. To date we have found more than 300 of these concepts of cost reduction. You may see more of them in the Improve/Costs section of StrategyStreet.

Digits Save Lives...and Costs by Improving Efficiency

Some hospitals, along with some health insurance companies, are using video technology to connect patients in outlying areas with specialists in urban centers. This video technology connects local and regional hospitals to large urban medical centers where most medical specialists practice medicine.

These video hook-ups provide information for both the specialist doctor and the patient. The specialist doctor has the benefit of a high definition video, both televisions and cameras, along with internet connected medical equipment and a nurse at the patient’s side to carry out instructions. The patient sees the specialist doctor on a video screen in the room.

The costs of these video systems have been declining. The typical system costs between $30,000 and $50,000. Thirty-five hundred hospitals now employ the system. These systems have a unit growth rate of 15% a year. They are about to become mainstream.

This innovation for both specialist doctors and patients offer us some good examples of cost reduction techniques.

We have examined several thousand examples of cost reduction efforts. There are four basic approaches to reducing costs:

* Reduce the rate of costs you pay for people, purchases and capital
* Reduce the costs that are not contributing to output because they are wasted or idle
* Redesign the product or the process to reduce components and activities
* Use fixed costs with more customers

The first two of these four basic cost reduction techniques improve the Efficiency of a cost Input. Efficiency measures the amount of Input required to produce an Output (Input ÷ Output = Efficiency). (See “Audio Tip #188: The Efficiency of the Input” on StrategyStreet.com.) For example, the number of labor hours required to produce a completed customer transaction.

If you reduce the rate of cost you pay for an Input, such as People, you reduce the effective number of people required to produce the Output. An employee making $20 an hour is effectively half of an employee who makes $40 an hour.

In our analyses of cost reduction techniques, we have seen seven major approaches to reducing the rate of cost:

-Purchase in larger quantities
-Reduce the quality of the Input
-Change the components of the rate of cost
-Use subsidies offered by third parties
-Request the supplier to lower its price
-Change the source of supply to a less expensive supplier
-Bring some activities in-house in order to achieve a lower rate of cost

The video technology reduces the rate of cost in the hospital system. It helps the hospital reduce the quality of the Input used in treating the patient without hurting the patient. This reduction in quality is not meant to be pejorative. Rather, it focuses high-cost activities on high-cost people by shifting lower value activities done by high cost people to lower cost people. It reduces the rate of People costs by separating tasks into high and low cost activities. Once the low and high cost activities are separated, lower cost people can do some activities previously done by high cost people. With the urban hospital specialist in charge, a nurse can now do more of the onsite work previously done by higher paid internists. The technology also offers the system the opportunity to lower the rate of cost it pays for square footage at its medical centers. The medical facilities in outlying areas have a lower cost per square foot than do those in urban centers. The outlying location is not as convenient to many patients, so its price per square foot is lower. The video technology overcomes the problem of distance.

The hospital may increase the Efficiency of its Inputs by reducing the proportion of Inputs that are not producing any Outputs. Inputs, such as People, are unproductive when they are sick or idle. If the hospital can find ways to reduce sickness or idle time, the same number of People Inputs will produce more Output. The efficiency of the Input rises as the number of People required per customer transaction falls.

In our research into the techniques that companies use to reduce the costs that are wasted or idle, we have identified several recurring patterns. The company may:

-Assist the Inputs, such as People, in increasing its efficiency
-Shift demand to use otherwise unproductive resources
-Improve the accuracy of the forecast it uses to plan work
-Use short term sources to meet peak demand
-Speed the process to reduce otherwise avoidable wait times

The video technology reduces unproductive or wasted resources. This technology speeds the process for the patient and the local attending physician. Diagnosis occurs more quickly due to the fast access to the distant specialist. All the parties involved at the outlying hospital spend less time waiting for a proper diagnosis.

Of course, these are just a few of the cost reduction concepts we have observed. To date we have found more than 300 of these concepts of cost reduction. You may see more of them in the Improve/Costs section of StrategyStreet.com.

In our next blog, we will discuss how video technology might reduce the hospital’s cost structure by using the latter two of the four basic approaches to reducing costs.

The Basis of Charge

Every price has at least two components: a set of performance benefits associated with the product and a unit price. The unit price is what we call the basis of the charge. This basis is the unit measure the company uses to quantify the price for the product. When you change the basis of charge, you usually change the effective price at the same time. Normally, the basis of the charge, or unit price, expresses a major cost that the supplier of the product incurs. A trucking company charges by weight. Lumber sells by dimension. Gasoline sells by a volume measure. Paper sells by weight.

Sometimes prices in a market are high enough that the suppliers don’t worry too much about their cost structures. (See the Perspective, “What Makes Returns High?” on StrategyStreet.com.) One example is the provision of internet services.

Not too many years ago, AOL, CompuServe and others charged internet users by the minute that the user was connected to the internet. But profits were high in the industry and the growth rates were impressive. Competition forced a change in pricing by changing the basis of charge. Instead of charging per minute of connect time, the industry moved to a flat rate monthly charge. This basis of charge allowed the internet user customer to use all the bandwidth he wanted for this flat rate. This made sense as long as industry profits were very high.

The industry evolved in ways that the early providers did not anticipate. Now the heaviest users of the internet use enormous amounts of bandwidth to download movies and other data. These heavy users are putting a strain on the network capacities of the internet service providers. Costs for some heavy users exceed the revenues they provide under flat rate pricing.

So there is a change coming in future pricing for internet usage. The single flat rate is about to give way to a basis of charge where the speed of the connection and the total usage of bandwidth are considerations for arriving at a price. Pricing is returning to a cost-based basis of charge under the weight of competitors.

AT&T is testing a new pricing approach in selected markets. Its lowest cost offering runs at $19.95 a month. It provides a speed of eight-tenths of a megabit per second with an overall monthly limit on downloads of 20 gigabytes. At the high end of the spectrum, the monthly price jumps to $65 for a service that offers a speed of 18 megabits per second and a monthly cap of 150 gigabytes.

This new AT&T pricing illustrates the shift from the pricing in a young, fast-growing industry, where costs seem less important than customer acquisition, to one where costs of the product become a differentiator of both the attractiveness of the customer and the efficiency of the supplier. (See the Symptom & Implication, “Revenue growth has been high, but has slowed” on StrategyStreet.com.)

A Lay-up for Lay-away

Toys R Us has introduced a lay-away program for large ticket items that they sell. These items include bikes, dollhouses, play kitchens, car seats, cribs, strollers and other expensive items. This new program from Toys R Us follows successful similar initiatives by Sears and K-Mart last year.

Lay-away programs have been relatively scarce for the last forty years. They were popular during the Depression. However, over the last couple of generations they have given way to the easy credit that consumers have had from credit card companies, banks and mortgage lenders. Of course, this day of easy credit seems to have passed. Hence, the lay-away program recovery.

The customer who puts a product on lay-away deposits with the store 20% of the item’s price, plus all taxes and a $10 service charge. The customer, then, has until December 6 to finish the payments for the products. The customer may make these payments at any Toys R Us store.

Toys R Us incurs real costs to offer this program. It has administrative costs, and probably some additional inventory costs as well, in order to make these products readily available once the customer’s payment schedule has been completed. This price component pays for these costs.

This is an example of an optional price component. Optional price components include such additions to the base price as fees on top of the normal basis of charge, penalties or bonuses for the buyer or seller, price caps, differing periods of agreement to maintain a price and extended payment options. A lay-away plan is an extended payment option. The company is offering this price option in order to increase its sales during a period where sales may be slow due to the current recession.

We have found many other examples of these optional price components, which enable a company to be more flexible with prices in difficult times. You may find these examples in the Improve/Pricing section of StrategyStreet.

The Challenge of a Small Competitor Part 2

Part 2: Pricing and Costs

There is a new, small, credit card issuing company in the market. The company is PartnersFirst and they promise to change the credit card world by making that world more cardholder friendly. This new firm, based in Wilmington, Delaware, has introduced an unusual credit card. The card has no fees and relatively low borrowing rates, along with less onerous penalties. The upstart company challenges the four giants in the industry, Bank of America, Citigroup, JP Morgan Chase and Capital One. Industry veterans formed and run this new credit card company. They believe that the company’s card should be particularly attractive in the light of new Federal rules that restrict credit card practices.

A few years ago, we did an extensive analysis of how a company whose market share was #3 or below in its industry could succeed against much better competitors. (See the Perspective “Rare Mettle: Gold and Silver Strategies to Succeed in Hostile Markets” on StrategyStreet.com.) More specifically, we studied these companies in hostile markets, where pricing pressure was intense and returns for most competitors in the industry were low. If a company could perform well in a hostile marketplace, its model would be instructive in all other marketplaces. We succeeded in finding a number of small competitors who performed well in these difficult markets. They had both growth rates and returns on investment above their industry averages. We named these successful smaller companies Silver competitors.

Once we found those successful competitors, we analyzed their business models to look for common patterns. Our analyses covered segments, product and service innovation, pricing and cost management. We will use our findings to evaluate the prospects for PartnersFirst. We will do this analysis in two parts. Part 1 of the blog covered segments and products. Part 2 will cover pricing and cost management and summarize our conclusions.

Pricing

As the market slips into hostility, the best Silver competitors may offer low prices to gain share. But chronic low prices are not their hallmarks. If the largest competitors in the market are in a Leader’s Trap, Silvers will exploit that price umbrella by discounting against the largest competitors to gain share. However, once the industry leaders match price discounts, Silvers eliminate their discounting. From that time on, they match the changes in the general price levels in the industry.

Silvers do have some price advantages in the customers they serve. Their customer portfolio of Large and Medium customers gives them a very few percentage point advantage over the largest competitors in average unit prices.

PartnersFirst offers very low pricing. Using the SEIU credit card as an example, the basic card carries a 16% interest, does not include any annual fees and imposes no late penalty charges. These prices are likely to stay low since PartnersFirst has agreed that it will not raise rates or change terms without SEIU’s permission. PartnersFirst makes money from the interest rate it charges borrowers. It foregoes the additional revenues from the high fees their credit card issuing competitors charge.

PartnersFirst’s prices virtually guarantee they will have low returns compared to the largest industry competitors. Their revenues per customer will be markedly lower than those of the industry leaders.

Costs

In tough marketplaces, Silver competitors achieve high returns by improving the Productivity of their cost structures. In general, the Silvers can not enjoy the Economies of Scale of the largest competitors in the industry. However, they are extremely disciplined in R&D, marketing, sales and in the general overhead functions. For example, they are fast followers, rather than innovators, in new products. They refuse to spend marketing and sales dollars to attract customers that do not fit their tightly defined profile. Few will undertake large advertising programs. This discipline allows them to have competitive costs.

They can, and do, produce attractive returns with their cost structures. An analysis of over 240 industries we did a while ago showed that companies ranked third or fourth in market share had a 22% and 24% probability, respectively, of achieving the highest returns among the top four market share leaders in the industry. (See the Perspective, “Is Bigger Really Better” on StrategyStreet.com.)

PartnersFirst suffers significant economies of scale disadvantages against the four largest Standard Leader competitors it faces. This disadvantage is compounded by the fact that PartnersFirst has to be very careful to extend credit card loans only to the best credit risks. So, rather than using the industry leaders’ low cost approach, employing automation and computer generated credit scores to determine a consumer’s ability to carry credit, the company has analysts who review each application by hand. This is a much more costly process than the largest competitors have.

Summary

Overall, PartnersFirst seems to have adopted a strategy with very low prospects for success. Its chosen segments are those most sought by the big four competitors. Its value proposition is very attractive to its target segments because it offers high service levels, superb Reliability and low prices. But the company cannot hope to compete in their competitive market with their high costs and low revenues per customer. The company faces a grim future.

The Challenge of a Small Competitor

Part 1: Segments and Products

There is a new, small, credit card issuing company in the market. The company is PartnersFirst and they promised to change the credit card world by making that world more cardholder friendly. This new firm, based in Wilmington, Delaware, has introduced an unusual credit card. The card has no fees and relatively low borrowing rates, along with less onerous penalties. The upstart company challenges the four giants in the industry, Bank of America, Citigroup, JP Morgan Chase and Capital One. Industry veterans formed and run this new credit card company. They believe that the company’s card should be particularly attractive in the light of new Federal rules that restrict credit card practices.

A few years ago, we did an extensive analysis of how a company whose market share was #3 or below in its industry could succeed against much better competitors. (See the Perspective “Rare Mettle: Gold and Silver Strategies to Succeed in Hostile Markets” on StrategyStreet.com.) More specifically, we studied these companies in hostile markets, where pricing pressure was intense and returns for most competitors in the industry were low. If a company could perform well in a hostile marketplace, its model would be instructive in all other marketplaces. We succeeded in finding a number of small competitors who performed well in these difficult markets. They had both growth rates and returns on investment above their industry averages. We named these successful smaller companies Silver competitors.

Once we found those successful competitors, we analyzed their business models to look for common patterns. Our analyses covered segments, product and service innovation, pricing and cost management. We will use our findings to evaluate the prospects for PartnersFirst. We will do this analysis in two parts. Part 1 of the blog will cover segments and products. Part 2 will cover pricing and cost management.

Segments

Silver competitors usually can not win a primary supplier role position with one of the industry’s largest customers. They rarely possess the infrastructure to serve these customers well. Instead, Silver competitors focus on the second sized tier of the industry’s customers. They focus on the industry’s large, but not the largest customers. As a rough rule of thumb, the largest customers in the industry, the industry’s Very Large customers, purchase 50% of the total industry’s volume. The second tier, Large customers, purchase the next 30% of the industry sales volume. The industry’s first tier of the Very Large customers may make up 7% of the number of the industry’s customers, while the second tier, Large customers, make up 13%. These are only rough estimates. The percentages will vary significantly across industries. (See Video #58: Customer Segmentation by Size on StrategyStreet.com.)

The Large customers that the Silver competitors serve tend to emphasize good service for a reasonable price in their own markets. These customers are not large enough to negotiate the industry’s lowest prices so they pay slightly higher prices than the Very Large customers.

Successful Silver competitors also seek out the better performing Medium size customers. Again using rough rules of thumb, these Medium sized customers may purchase 15% of total industry volume and represent 25% of the total number of industry customers. The best Silver competitors focus their attention on Medium customers who are service-oriented in their own marketplaces.

PartnersFirst’s business model seeks some of the industry’s largest customers, Very Large customers. One of them is Service Employees International Union (SEIU). This union signed PartnersFirst to create a branded card for its two million members.

PartnersFirst pursues some of the industry’s first tier customers by offering an Affinity credit card. With an Affinity credit card, a sponsoring organization, such as the SEIU, agrees that the credit card issuing company will have the exclusive right to brand the credit card with the sponsoring organization’s brand and then market it to the members of the Affinity group. In order to win this business, the credit card issuing company must make a substantial payment to the sponsoring organization. Other sponsoring organizations for PartnersFirst include the Chicago Bar Association and Golf Magazine.

PartnersFirst is flying straight into the headwinds of competition with the biggest industry competitors for this industry’s Very Large customers.

Products and Services

In products and services, the best Silver competitors distinguish themselves by offering service levels that competitors achieve only sporadically. If the Silvers have channels of distribution, they rely solely on them to sell to the end user. They also protect the revenue base of the channel. The successful Silvers will cover a relatively broad spectrum of Price Points within the industry, but will not offer a Price Point that their target segments will not buy. Because Silver competitors concentrate on customers who offer high service levels themselves, these customers tend to buy a mix of product Price Points skewed toward the higher end of the market, which helps the Silver competitors’ profit margins.

PartnersFirst emphasizes service and Reliability in its benefit package. It tries to make the card holders experience a good one. It listens, and responds, to its sponsoring organization customers. PartnersFirst allows its Affinity partners a say in the terms of the credit agreements on the credit cards. For example, the Affinity’s groups must sign off on any changes in rates or fees that PartnersFirst would like to make.

The company’s business model appears to fit nicely with the successful Silvers’ approach of offering high service to their customers, and of emphasizing Reliability in the customer relationship and company benefit package.

Part 2 of this blog will examine PartnerFirst’s pricing and costs.

The NFL Starts to Play Defense

The NFL is the most popular sports league in the country. For years, it has been able to increase its revenues by selling television time, licensed products, and even tickets to games. This easy market came to an end with this recession. Three quarters of the NFL clubs have held ticket prices flat this year. Even then, only twenty clubs sold out the tickets for their home games. So, ticket sales revenues are likely to drop this season.

All is not lost, however. The Fan Cost Index measures the average price for a family of four to buy four tickets, parking, drinks, hot dogs, beers, programs and caps. In 2009, that index stands at $413. The Index is up 4% over the last year. While the Consumer Price Index is falling, the league still has found a way to raise prices.

Still, some in the league are beginning to become concerned about the fall-off in demand for tickets (see Video 8: Full Explanation of Future Direction of Margins on StrategyStreet.com). These people are taking the first tentative steps in defensive pricing, that is, reducing prices in a falling price environment.

When prices begin falling, a shrewd company will begin to increase the detail with which it prices. It will begin pricing in such a way that price-sensitive customers begin getting lower prices, or more benefits, while everyone else continues to pay the higher, regular, price. (See the Perspective, “Meeting Falling Prices with Creativity” on StrategyStreet.com) This increased detail in pricing does raise administrative costs, but it preserves even more revenues and, so, preserves margins.

A company increases the detail at which it prices by exploiting more of the potential components of a price. These price components include performance benefits, discounts, the basis on which it charges for its product, the period of price agreement and some optional components, such as fees, penalties, price caps and extended payment options. A company using these components is able to restrict the lower prices to selected customer segments and, thereby, reduce the loss of revenues and margins from a broader price decrease.

The NFL is just beginning to stick its toe into defensive pricing waters by using some of these components. The Detroit Lyons are creating an All-You-Can-Eat seating section this season, where fans can eat all the hot dogs, bratwursts, nachos, chips, popcorn and soft drinks they want for a fixed price. This is a change in the performance benefits of the product. The New Orleans Saints are allowing customers to pay their season ticket bills in installments. Of course, the fans have to pay a 1.9% transaction fee. Here, the Saints are using an extended payment option and then adding back a fee to recapture some cost. This approach reduced one component and increased another. The Kansas City Chiefs offered an extended payment option when it allowed its customers to spread their season ticket purchases over four payments. The New York Jets, the Chiefs and the Jacksonville Jaguars have changed the basis of charge for their season tickets. These clubs have introduced half-season plans to offer a cheaper alternative to full-season tickets.

If the recession continues, these will be just first tentative steps. (For more on pricing see, StrategyStreet.com/Diagnose/Pricing.) Pricing can get much more complex and precise as a market becomes more hostile. Consider the airline industry as an example of precision pricing.

The Tables Have Turned

Just a few years ago, Dell Computer was the darling of the PC industry. Hewlett-Packard was an also-ran. Today the tables have turned. Over the last year, Hewlett-Packard’s market share has jumped from 18.5% to 20% of the global PC shipments. Dell’s market share has fallen from 15.7% to 13.7%. The change in market share is customers saying that HP offers a better value proposition. (See the Perspective, “The Two Best Consultants in the World” on StrategyStreet.com.)

HP has strenuously reduced its costs at the same time it has gained market share. HP, at one time, was in the middle of the PC pack in costs. Today, its PC operating margin is 4.6%, better than Dell’s operating margin. The superior cost performance of HP is the competitors acknowledging that HP has a lower overall cost.

HP has gained much of its market in the retail side of the business, especially with lower-end products. Most Standard Leaders don’t like lower-end products because they offer low margins and not much reputation (see StrategyStreet/Diagnose/Products and Services/Innovation for Customer Cost Reduction/Price Point Bias).

HP is gaining some of its new market share with very low pricing, a characteristic that used to belong to Dell. Wal-Mart’s recent experience with HP is indicative of the company’s current aggressiveness. Wal-Mart wanted to sell a personal computer for less than the price of the hot Netbook products. Netbooks are mini laptops costing less than $500. Wal-Mart did the consumer research to produce specifications for the proposed full-sized laptop product and passed those to some PC companies. Several responded positively. Dell offered a product for just under $400. Toshiba and Acer offered a product priced just below $350. HP beat all the competitors, though, with a $298 machine.

Dell is allowing Hewlett-Packard to take market share with its low prices because it sees little profit in the low-priced machines. But there is a problem here. HP has already proven itself capable of using its large size to streamline logistics and extract lower purchases of costs from its suppliers. It has smartly redesigned its products to reduce their costs. How is it, then, that Dell, or anyone else, believes that they will be better off by ceding market share to Hewlett-Packard on the basis of low prices? Will Hewlett-Packard become weaker? Will the PC companies losing share become stronger? This is another example of companies in a Leader’s Trap.

Hostility's End Game

The late 80’s and 90’s were hostile times for the beer industry. The period saw constant price wars. All the domestic competitors, except for Anheuser Busch, suffered from relatively low returns. A hostile industry is notable for constant pricing pressure and very low returns in the industry. The brewing industry certainly fit that description for a long period of time.

Then came the 2000’s. This decade brought a great deal of consolidation to the market. InBev bought Anheuser Busch. SabMiller PLC consolidated operations with Molson Coors Brewing Company. These changes, and others, produced a consolidated industry. Today, the two largest companies control 80% of U.S. beer sales. These companies have introduced products at every price point so they dominate the market at virtually all Price Points.

This dominance gives the industry Standard Leaders pricing leverage. Over the last year, the price of beer, ale and other malt beverages grew 4.6%, while overall consumer prices in the U.S. fell 2.1%. The beer makers now have pricing power that looks much like that of the breakfast cereal makers and cigarette manufacturers. The brewers are able to raise prices, even in the face of declining unit volumes, just as the cigarette manufacturers are able to do. Profits in the domestic market are rising at more than 25% a year. (See the Perspective, “What Makes Returns High?” on StrategyStreet.com.)

Hostile markets end in one of two ways. (See the Perspective, “What Ends Hostility?” on StrategyStreet.com.) Either demand bails the industry out or industry consolidation shifts pricing power back to the industry. In our extensive work in hostile markets, we have observed that three quarters of the time demand growth bails out a hostile industry. The demand in the industry grows and gradually sops up excess capacity. As the excess capacity ebbs away, pricing power returns to the industry participants in order to encourage the addition of the capacity that the customers will need in the future. In the other quarter of the cases, the industry consolidates until four or fewer competitors own at least 75% of the market. And, all remaining competitors must have reached the conclusion that trying to gain share with low price is an exercise in futility. The beer industry has consolidated far more than the average industry. In the average domestic industry, four competitors to own 85% of the total industry market share. In brewing, it only takes two to approach that concentration. (See more on StrategyStreet.com/Tools/Benchmarks/Market Share)

Not many industries succeed at reaching this degree of consolidation. But once they do, the world is their oyster.

You Mean I Have to Pay for This?

Those of us who fly a lot have noticed how few people have a meal on an airplane anymore. In flight food was attractive when we got it for free, much less so when we have to pay for it.

The WiFi industry is learning a similar lesson. A couple of WiFi suppliers to the airline industry are trying to figure out how to charge for their services. (The WiFi suppliers control the pricing so that the airlines can not give it away, as they have tended to do in the past with other benefits…though that trend certainly has ended.) The WiFi suppliers have found that when the service is free, many customers use it. But when they charge for the service, even at the low price of $1.00, usage drops drastically off.

The companies are trying price schemes that are tied to the length of the trip. One plan charges $12.95 for the service when the flight lasts longer than three hours and $9.95 for flights from ninety minutes to three hours. If the flight is shorter than ninety minutes, the price is $5.95.

The WiFi sellers need about 10% of travelers to pay for internet access in order for the service to be profitable. That will be difficult. A few flights have seen usage in the 12% to 15% range, but they tend to be on longer flights. A large percentage of U.S. domestic flights last less than two hours.

The WiFi suppliers, though, are coming up with a different approach to pricing that is much more likely to succeed. One approach will be to sell packages of service. A business traveler might buy a package of five flights for a fixed price. Once the price has been paid and is out of the customer’s mind, it is more likely that the service will appear attractive while the traveler is on the airplane. In addition, it should be much cheaper to sell a package of five, ten or fifteen flights than it is to sell one unit of service on each flight. In another approach, the WiFi companies are planning to negotiate directly with companies to sell their services in bulk to the companies for use by their employees. This approach has even better cost savings than the package sales. It is a much more efficient way to go. Both of these approaches change the price by altering the basis of the charge for a unit of sale.

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From Cheap to Chic

Do you know what a Hyundai is? How about a Kia? Of course you do. They are South Korean automakers. Though they are not top of the consumer mind in the U.S., they are a rising pair. They both belong to the Hyundai-Kia Automotive Group. Globally, this automotive group is the fourth largest automaker. Toyota, General Motors and Volkswagen rank ahead of them. And the South Korean Group is gaining share at a rapid rate. Ten years ago it was the eleventh largest global automaker.

In the United States, Hyundai and Kia began life as Price Leaders. They produced small, cheap cars with relatively low quality. Twenty years ago, these manufacturers’ cars might have been a close substitute with a used car. Not so any more.

Hyundai has become better known with its 100,000 mile warranty, the best in the auto business. The company realized its poor quality reputation was holding it back and invested to improve quality. To convince the U.S. consumer that it was serious, it offered the best warranty in the business.

Hyundai is no longer simply a Price Leader. It has become a true Standard Leader. It has migrated up through the Standard Leader product class, with the Sonata, and has even entered the lower end of the Performance Leader class with the new Genesis. All of the company’s offerings, though, carry lower prices than those of competition.

The combination of low prices and good quality has propelled Hyundai, even in the hostile auto industry. Hyundai sales in the last year grew by 47%, while industry sales were up only 1%.

Hyundai is a good example of a Price Leader who morphs into a Standard Leader over time by offering good performance for a low price. (For more information on Price Points, visit the Diagnose/Products and Services section StrategyStreet.com.) Most Price Leaders don’t try to do this, but a few carry it off with aplomb. Hyundai is one of them.

Clever Pricing from Toys R Us

Toys R Us has created the “Great Trade-In” event. This event offers consumers who bring used cribs, car seats or other baby products into a Babies R Us or Toys R Us location a 20% discount on any new product from selected manufacturers in the store.

In a public relations explanation, the company calls this event an effort to keep potentially unsafe children’s items from being resold. But a more realistic spin on this event is that it is a trade-in discount that increases the company’s store traffic.

The trick with discounts always is to control the percentage of the market that qualifies for the discount while still giving the company credit for offering low prices. Companies do this by carefully selecting both the segments that qualify for the discount and the form of the discount itself.

A trade-in allowance is a form of discount. There are at least nine of these forms in common usage, including rebates, coupons, discounts in kind, and several others. Most of these forms reduce the effective cost of the discount for the company. These forms of discount, along with the segments that are eligible for the discount, help a company control the spread of the discount to specific customer segments. In our work to analyze pricing through discounts, we have found that there are at least eighteen common customer segments which companies use. This Toys R Us discount is a loss leader discount, which goes to customers who come to a store in order to get a low price on a product and then may stay to buy other, higher-margined, products.

For more on pricing, see StrategyStreet.com/Improve/Pricing/Brainstorming Ideas.

As Small as a Man's Hand

After several years of extreme drought in Israel, the prophet Elijah sent his servant to look on the horizon for a cloud. The servant returned to say that he had seen a cloud on the horizon but it was as small as a man’s hand. However, in short order, that little cloud turned into a deluge and ended the drought in Israel. This story had a happy ending. There is a small cloud on the horizon for consumer goods that may not have such a happy ending. The retail market share of consumer goods is falling, while that of private labels is growing.

Consumer goods are a special case when we look at low-end, Price Leader, competitors (see Audio Tip #83:
Price Leader Products and Companies on StrategyStreet.com). On average, private labels sell at a 25% discount to branded consumer goods. At the same time, these private label products offer their retailers better margins than do consumer goods. You may be asking yourself, how can the private label producers charge 25% less and still offer better margins to the channel of distribution. The answer lies in the cost of goods sold.

In consumer goods, the cost of goods sold represent a smaller percentage of total revenues than in most other industries. On the other hand, the cost of the marketing and the sales of consumer goods is high. Private label suppliers turn over most of the cost of marketing and sales to the retailers. They have to worry primarily about their cost of producing and delivering the products.

For the last several years, branded consumer goods suppliers have been able to raise prices at will. The branded consumer goods manufacturers needed part of these price increases to cover escalating commodity costs. But another part increased their profit margins. Private label suppliers have been able to compete underneath this price umbrella (see Audio Tip #119: A Price Umbrella on StrategyStreet.com) in ways that should frighten the branded consumer goods manufacturers.

The private label suppliers have kept their pricing and margins attractive for their retail channels of distributions. At the same time, though, they have reinvested in the quality of their products under the price umbrella provided by the branded manufacturers. It is getting increasingly difficult for a consumer to tell the difference between private label and its branded competitor.

This difficulty in differentiation is showing up in market shares. Today, private label consumer goods have as much as 20% market share in Wal-Mart, where branded consumer goods carry low prices already. In retailers with higher branded consumer goods prices, private labels have an even higher market share. They control about 35% of the sales at Kroger.

Since these market shares for Price Leader products are very high, you might assume that they are unlikely to go higher. That may not be the case. In Germany, private labels now account for nearly 40% of consumer goods. That’s up from about 20% ten years ago.

A small part of this share shift may be that consumers are shifting their purchases downscale in this tough economy. But that is only a small part of the story. This market share shift to private label products has gone hand in hand with the rise in real prices of the branded consumer goods.

Today, many of the branded consumer goods producers are cutting their prices and increasing their product sizes in order to compete with the private labels. But these branded consumer goods companies may need to go much further (see Audio Tip #105: What is the Effect of a Price on StrategyStreet.com). They may need to reduce prices low enough to force private label suppliers to reduce the content and quality of their products so that the differences between their products and the branded products are clear to the consumer. If the branded producers leave their prices high enough to be comfortable for these private label suppliers, these Price Leaders will continue improving their quality and taking market share from these branded industry Standard Leaders.

Slowing up Hulu?

The U.S. online video ad market is growing at 30% a year. Still, it is just a small fraction of total U.S. T.V. advertising spending. The leader in the online market is Hulu. GE’s NBC Universal, News Corporation, and Walt Disney are Hulu’s owners. Hulu and some other video sites provide free professionally-produced videos from its investors. Hulu exists on an advertising business model. Hulu will place one or two thirty-second ad spots during a few commercial breaks for hour-long shows.

Since this market is showing so much growth, the leading cable firms, Comcast and Time Warner Cable, have decided to respond. Comcast has introduced OnDemand online and Time Warner has created TVAnywhere. These are cable trials offered only to existing pay TV subscribers. The paid subscribers get the professional video from cable networks for free. The cable programmers, though, may be putting the same number of ads online as they show on traditional TV, considerably more than Hulu.

What would be the effect of this development on Hulu?

Suppose we divide the world into two types of people: Comcast and Time Warner cable subscribers and everyone else. Clearly the Comcast and Time Warner cable subscribers are going to be better off. They have an online channel to view content for which they have already paid. They just have to watch commercials in the process. (See Audio Tip #64: The Objectives of a Performance Improvement Program on StrategyStreet.com.)

On the other hand, the part of the world that views Hulu will not be affected at all by these online offerings from Comcast and Time Warner. They will continue watching just as they have over the last few years. Hulu will still have its own exclusive content. Hulu’s growth will not slow.

In the long run, there was probably room for both models. Both the cable companies and Hulu offer exclusive content. They will continue to attract viewers who prefer their proprietary products, just as major network and cable networks do today. In this longer run, the market share prize will go to the company offering the most attractive proprietary content.

The addition of OnDemand online and TVAnywhere are good product and service improvements from the cable companies but they won’t slow Hulu’s growth in the least.

The China Plan for Purchases

China has adopted an interesting plan to reduce the rate of cost it pays for the metals and ores it purchases.

China is a big consumer of stainless steel. It needs nickel to produce this stainless steel. While it has some mines of its own, it needs to import nearly a quarter of its total needs. To fill part of these needs and to give itself some leverage against the largest suppliers of nickel, China has begun forming alliances with the smaller nickel companies. In some cases, China has made an investment in the smaller miner. In other cases, China has guaranteed to take a certain amount of these miners’ production at a fixed price. These alliances have helped the small miners avoid the worst of the repercussions of limited availability of credit in the current economy.

China is trying something similar in the iron ore market. The top three iron ore producers, Rio Tinto, BHP Billiton and Vale control about 70% of the iron ore transported by sea. China has been unable to break the unified pricing approach of these big three suppliers, so it went around them. Recently, it made an agreement with a small iron ore producer, Fortescue Metals, to purchase iron ore at a 3% discount to the international price being charged by the big three. In return, Fortescue will get up to $6 billion in financing from the Chinese to put to the expansion of its business (See Video #40: Price Shaver on StrategyStreet.com).

In both these arrangements, China is trying to make a small supplier a lever against a very large supplier to drive down the price. This usually does not work, for two reasons. The first is performance. A smaller suppler simply can not provide for most of the needs of a Very Large customer, such as China. Small suppliers usually can compete only in a limited geographic market and with a limited product range. The second reason is one of cost. Commodity markets are extremely competitive. Scale counts for a lot. Economies of scale rule! (See Audio Tip #195: Economies of Scale and Their Measurement on StrategyStreet.com) The smaller competitors will not have the same economies of scale as the larger competitors. The discounts that the smaller competitor must give up in order to secure the business of the Very Large customer more often than not serve to weaken the ability of the smaller competitor to perform to the same level as the largest competitors in the market.

I think China will find that if it wants to break the strangle hold of the largest suppliers in the market place, it will have to convince one of the largest suppliers, rather than one of the smallest, to discount for it.

Membership Privileges

The snow skiing season is still a few months away. Still, in preparation for the upcoming season, the ski equipment promotions are underway. One of my favorites comes from Granite Chief. This is a fine retailer of ski equipment in Truckee, California. Each year, the company makes an offer to its customers: Purchase your Ski Service Card by August 31st for $100 and you will have a credit balance for $200 to be used on any of the company’s repair, mounting, tuning and boot-fitting services. Each time the card holder has equipment serviced by the store, Granite Chief will deduct the labor cost from the customer’s Ski Service Card credit. The credit is good only for labor. Any unused balances are not refundable and will not be carried over to the next season. The card expires on May 31, 2010.

This is a common approach to discounting (see Video #43: Four Simple Pricing Rules in Hostile Markets on StrategyStreet.com). The trick with a discount is to limit the customer segments who qualify for the discount. In this case, the store limits the discount to those who purchase a membership card. The store, then, further limits the discount to a total dollar amount.

We have seen many examples of club member discounts over the years. These discounts go to customers who have a particular relationship with the company. In some cases, the relationship is that of employee. For example, Delta subsidized new computers for its employees in a program it sponsored with PeoplePC. In other cases, the relationship is a bit looser. These are often “friends and family” programs that extend discounts to chosen customers. For example, recently Saks offered 25% off to “friends and family.” In a similar program, Banana Republic offered 25% off to its “friends and family” holiday shoppers. The codes for this discount program circulated by email on the internet. Not exactly exclusive, was it?

The Granite Chief program is an example of the second type of club member program. These programs offer discounts to members of company-sponsored clubs or affinity programs. Here the company is more specific in the definition of the customers who qualify for the discount. Programs falling into this category include frequent shopper cards offered by grocery stores. In another example, Chico’s, the apparel retailer, offered its best customers membership in the Passport Club. This club offered a permanent 5% discount for every $500 the customer spends.

All of these club member discount programs increase total sales and confirm customer loyalty. For more on approaches to discount products in ways that limit the discount to select customers, please see StrategyStreet/Improve/Pricing/Brainstorming Ideas/Change the Components of the Price.

The eBook Competition

Amazon and its Kindle products have had the eBook market to themselves since the market began taking off a couple of years ago. The eBook market is now starting to grow fairly fast. Sony has decided to grab some of that growth.

Sony is entering the market with three price points: a $199 entry product called the Reader Pocket Edition, the $299 Reader Touch Edition with a touch screen and the high-end Reader Daily Edition at $399 with both touch screen and wireless capability.

Very fast-growing markets see market share changes due to Function and Price innovations. Let’s use the Customer Buying Hierarchy (see Audio Tip #95: Customer Buying Hierarchy on StrategyStreet.com) to evaluate Sony’s prospects against Amazon.

The Customer Buying Hierarchy holds that customers buy using four major criteria: Function, Reliability, Convenience and Price. Customers go through the hierarchy in that specific order and purchase when there is one, and only one, competitor who can offer them a unique benefit.

Function refers to the way the customer uses the product. Function innovations in this eBook market are two types: hardware innovations and content. In hardware, Sony has two Price Points with a touch screen capability that Kindle does not offer. On the other hand, the regular Kindle 2 offers wireless downloads. The only Sony product that offers wireless is the high-end Reader Daily Edition at $399, compared to Kindles’ $299 Price Point. Without considering price, it is hard to call a winner when the Kindle 2 offers wireless connectivity while the Sony offers a touch screen.

Content is likely to be a different story. Sony has adopted the ePub format, which is an international format for digital books and publications. Amazon, on the other hand, offers eBooks which can be read only on Kindle 2 devices, a proprietary approach. Sony argues that its readers can download books from the local library using its format, saving costs. But libraries have only a limited number of digital copies of books available. And, if the market takes off, the authors and publishers are likely to severely limit the number of free library copies available to ereaders. Kindle, for its part, is the progeny of a book retailer. There are many books available through Amazon for the Kindle 2, far more than will be available for the Sony products. In addition, the Apple iPhone and the iPod Touch also allow their owners to read books in the Kindle 2 format. With its extensive experience and product platform already in the market, content providers are highly likely to choose the Kindle 2 format before choosing the Sony format, if they must make a choice. Certainly in the early going, the content, and thus the Function advantage, goes to Amazon and it’s Kindle 2.

Reliability refers to how a company keeps the promises it makes to its customers. For an end user customer, Reliability means that the product works and will be fixed promptly if it does not work. Amazon has a superb reputation for Reliability among consumers. Sony’s reputation is also good. However, since Sony produces mostly electronic gear, its reputation is unlikely to be as good as that of Amazon, who sells mostly digital products. I would guess Amazon gets a slight nod in Reliability.

Convenience refers to the ease with which a customer can buy and begin using the product. Sony’s products will be in 9,000 retail outlets, including all the leaders in the industry, this holiday season. Amazon sells its Kindle online. The customer can see and touch the Sony products in the many retail outlets. Seeing and touching a Kindle is much more difficult for the perspective Amazon customer. The nod in Convenience clearly goes to Sony.

Price is the last consideration. The Kindle 2 product has a price of $299. The Sony Reader Daily Edition has a price of $399. As we noted above, the Sony product offers a touch screen at this price. Kindle does not, at least not yet. The Sony product is a third more expensive than is the Kindle. This additional price is likely to make the Sony product a Performance Leader product (see Audio Tip #82: Performance Leader Products and Companies on StrategyStreet.com), rather than a true competitor for the leading Standard Leader position.

It is going to be difficult for Sony to make the $399 product the most common product in the market. Amazon’s Kindle has already established the industry standard for benefits and price. Sony would have been more successful offering its touch screen benefits at no price increase over the Kindle 2 Standard Leader product. Sony looks to be in a Leader’s Trap here. It will eventually have to reduce that price or see the product garner relatively little market share, likely well below 15% of the market.

Both Sony and Amazon would probably be better off if they responded to the content challenge each offers the other. Sony might try to license the Kindle software and offer that format, as well as the format. Then Sony could have competed on its strengths in making small electronic equipment. Amazon could add the ePub format to its software and open up a new world of content for its customers. This will become imperative for Amazon if a great deal of content comes available in the ePub format that is not also available in the Amazon proprietary format.

Sony in the Game Business

Sony has just introduced a new PlayStation3. This product comes in a new slim form factor. Its price is $299. This is a 25% reduction from the $399 price of the current model of the PlayStation3. The price cut comes as the PS3 has struggled against its competitors, whose products have carried lower prices. Sony was in a Leader’s Trap.

Not only is the PS3 struggling against lower-priced competitors, it is also facing the head winds of a badly depressed market. Industry sales of game hardware and software are down 29% from a year ago.

The problem? Even at the new price, the product is more expensive than the industry leader. Nintendo’s Wii console sells for $250. The wildly successful Wii sets the price bar for the heart of the market. Its total console sales have passed 20.7MM compared to just over 15.5MM for the Microsoft Xbox and about 7.9M for the PS3. A competing console price higher than $250 really focuses the customer’s attention on the value of the marginal benefits.

Sony justifies the fact that the PS3 will remain the more expensive console because it offers a Blu-Ray player. Customers may not see it that way (see the Perspective, “The Two Greatest Consultants in the World” on StrategyStreet.com). The new PS3 may end up as a high end, Performance Leader, product with limited market share.

Sony has climbed part way out of its Leader’s Trap (see Video #42: Leader’s Trap on StrategyStreet.com) but still has a way to go. You will see more of the same in our next blog.

Couponing and Price Leaders

In the bleak economy in the first half of 2009, coupon redemption rose 19% compared to the same period in 2008. Even the largest Price Leaders (see Audio Tip #83: Price Leader Products and Companies on StrategyStreet.com) have had to go along with this development. The three largest discount clubs, Costco Warehouse, Sam’s Club and BJ’s Wholesale Club have increased their couponing to club members. (See Audio Tip #120: Using Low Price to Gain Share in Hostile Markets.)

Each of these three clubs carries a membership fee to join the retailer. These club membership payments entitle the retail shopper to take advantage of the large scale purchase economies each of these stores enjoys. The stores pass on these purchasing economies in the form of low prices for their members. Often these low prices alone are enough to provide these club-oriented retailers with attractive sales growth. However, even they have suffered in the bad economy of 2009 as consumers have spent less on discretionary items.

Now each chain is offering tailored coupons to selected members. Sam’s Club offers electronic coupons through kiosks at its stores. Today these coupons are offered to its highest paying membership categories, the Advantage and Business Plus cardholders. With the new coupon program, these selected members will receive three new coupons, good for about a month.

BJ’s has traditionally accepted manufacturers’ coupons which Sam’s does not accept. In the last few years, it has also provided members with coupons available at its web site for purchases in its stores.

Costco has been offering once-a-year coupon books, containing discounts with expiration dates staggered throughout the year. This keeps customers coming back to take advantage of the discounts. About a year ago, it began sending monthly coupon books with discounts expiring after four weeks.

In a tough market, even the lowest-priced of the Price Leaders have to offer something extra to keep the customers coming in.

A coupon is a form of discount (see Audio Tip #114: The Key Components of a Price on StrategyStreet.com), the method a company uses to convey a discount to a customer. Our research has determined that there are eight other forms of discount. Many of these forms reduce the cost of the discount to the company, while giving the full value of the discount to the customer.

Nokia Scores...and Fumbles

Nokia is an industry Standard Leader who struggles at the high end of the market.

Nokia demonstrates its grasp of the mass market with a recent pricing innovation in India. In that country, Nokia owns half the market. In order to encourage further growth in the market, Nokia plans to roll out new handsets in twelve rural Indian states. In these states, the company has allied itself with a microfinance organization that is buying the handsets from Nokia and selling them to women in rural areas on the installment plan for 100 rupees a week. 100 rupees is equivalent to about $2. These weekly installments continue for 25 weeks, for a total cost of $50 per phone. Nokia’s program makes phones more affordable to these new customers by providing them an extended payment option.

Nokia is not without its struggles, however. In the smart phone market, the company is beginning to lose share at a rapid rate. While still an industry leader, Nokia’s smart phone market share has fallen from 47.5% a year ago to 45% today. Apple and Research In Motion are the beneficiaries of Nokia’s share slippage.

This smart phone market is important to all industry participants. Smart phones are growing their share of the market. The Standard Leader phones are declining in sales, while smart phones continue to grow. They now account for 14% of the total handset market, up from 11% last year. These smart phones are Performance Leader products with substantial margins. They increase company profitability as well as growth.

One problem Nokia seems to be facing is that its applications don’t have the same ease of operation as do Apple’s offerings. Apple’s applications work better with one another than do Nokia’s. And Nokia has been slow to bring new functions to the market.

Nokia may be suffering from a phenomenon we call Price Point Bias. (See Audio Tip #89: Price Point Bias on StrategyStreet.com.) Price points, other than the Standard Leader price point, often cause Standard Leaders problems in an industry. Marketing oriented Standard Leaders dislike Price Leader products because they view them as trojan horses for lower market prices. Many also believe that low priced products depreciate the quality of the company’s brand name. At the opposite extreme, Standard Leaders dominated by an operations culture dislike Performance Leader products. They view these products as disruptive to the smooth flow of operations and to the low costs that smooth-running operations create.

For more information on this phenomenon, see StrategyStreet/Diagnose/Products and Services/Innovation for Customer Cost Reduction/Price Point Bias.

Pricing Confusion and Its Aftermath

There were a number of articles regarding pricing over the last few days that caught my attention. Whenever a market gets difficult, many competitors, but especially the leaders, can become confused about what to do with their prices. Here are some examples of both effective and ineffective pricing decisions.

Delhaize is a Belgian-based supermarket operator. In the United States it operates Food Lion, Hannaford and the Sweet Bay chains. The company saw its sales grow and market share increase during the second quarter of 2009 because it offered comparatively low prices and pushed its own low-cost private labels. The company’s market share gains came at the expense of competitors who did not emphasize low prices. Among these were Supervalu and Safeway. Both of the latter competitors now pledge to cut prices aggressively.

Unilever has a new Chief Executive, that is, he was new as of January 2009. The previous CEO had held prices relatively high. The new CEO quickly reversed course. The company cut prices all across Europe and sales began to grow. Not by much, but they did grow. And the company gained market share. In contrast, Procter and Gamble saw sales fall in the same period. Part of Unilever’s new low price emphasis is to respond quickly to cheap local brands. For example, in South Africa, the company’s Standard Leader laundry detergent came under attack from a less-expensive local brand. In response, Unilever launched an inexpensive version of its Surf detergent with fewer features. This new Price Leader product effectively countered the inexpensive local brand.

Joseph A. Bank Clothiers has continued to see its revenues and margins increase despite the very tough detail economy. The company sells classic fashions and casual clothing for men. It has always been a promotions-driven company. It cleverly offers selected discounts to keep customers coming into its stores. In the spring, it offered a $199 suit sale and then, recognizing its customers’ fear of job losses, promised to refund the price of the suit, and let the customer keep the suit, if the customer lost his job before July. Suit sales bounded and same store sales grew by more than 4%. The company continues to gain share from department stores and other specialty stores whose pricing is not as sharp.

Note that in each of these three examples, the company gaining share because of its low price would not have been able to do so had the other competitors in the market not allowed them to get away with the lower prices. The competitors who lost share were in a Leader’s Trap. (See the Symptom and Implication “The industry leaders are losing share” on StrategyStreet.com.) There is no good ending for a company in a Leader’s Trap.

Here is an example of pricing acumen from the U.K. grocery industry. A few months ago, Asda, the British unit of Wal-Mart, and Tesco, the industry leader, began reducing prices and issuing new advertising messages stressing their low prices. Within a very short period of time, the other two leading grocery chains, Sainsbury’s and Morrison’s, followed suit. Each of these chains are now emphasizing low low prices and private label products. The result? All four chains are growing and picking up share. The losers are the smaller, independent retailers who simply can not afford to dive to the depths of the discounts offered by the bigger guys. (See the Symptom and Implication “As large competitors match low prices other competitors face difficulties” on StrategyStreet.com.) The U.K. industry’s customers have not defected to discounters. There was no Leader’s Trap in this market as each of the largest competitors matched competitive prices quickly.

For more explanation and examples of the Leader’s Trap, see the Diagnose/Pricing/Price Change Opportunities/Price Discount Opportunities section of StrategyStreet.com.