Sometimes Smaller is Better

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

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

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

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

Nokia Makes a Bet in the Smart Phone Market

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

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

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

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

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

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

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

Abercrombie - Recovering in a Falling Price Environment

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

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

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

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

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

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

A Fast Growing Market Begins Developing Reliability and Convenience Innovations

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

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

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

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

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

Costs - The Problem with Weak Constraints

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

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

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

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

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

I Guess it Takes Bankruptcy...

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

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

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

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

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

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

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

Green Shoots and Attitudes and Jobs

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

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

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

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

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

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

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

The ETF Arms Race

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

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

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

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

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

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

Vanguard vs. Fidelity

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

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

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

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

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

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

Previews of Coming Attractions in Public Services

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

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

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

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

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

Dominick’s Finds a Way to Reduce Price…Successfully

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

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

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

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

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

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

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

Microsoft Phone 7 - A Long Row to Hoe

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

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

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

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

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

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

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

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

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

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

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

The Fall of an Industry Leader - Part II

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

In Part 2, we will look at some of the highlights of Blockbuster’s pricing over the last few years.

This may seem surprising, but the industry’s prices began their long-term decline as early as 1982. This is not unusual. Fast-growing industries often see price declines as new competitors enter the market with plenty of capacity to serve even fast-growing demand.

* In the early 90s, Blockbuster changed its pricing scheme. It had offered a movie for two nights at $3. Blockbuster changed its price to $2.50 per night. It also charged late fees. This change in pricing hurt smaller competitors, who often got business when Blockbuster was out of product due to its two-night rental policy.

* By 1994, Blockbuster felt it could raise prices with impunity, and it did raise prices. (See the Perspective, “Can We Raise Margins With a Price Increase?” on StrategyStreet.com.)

* By 1997, prices were coming under pressure due to the fall-off in demand growth caused by other forms of competition. Blockbuster and its video tape competitors had to begin reducing prices. (See the Symptom & Implication, “The Industry is Seeing its Frist Price Wars” on StrategyStreet.com.)

* In 1997, Blockbuster introduced customer loyalty campaigns to hold on to its most important customers. By then the company was earning less than its cost of capital.

* In 1999, Blockbuster introduced a rewards card. The card cost about $10 and allowed a card-holding customer to obtain one movie free each month. It also offered one free movie for every five rented in a month, and one free “Favorites” on Mondays, Tuesdays and Wednesdays. This was an attempt to create greater sales with existing customers. Movies rented for $4 a night, but late fees could often double or even triple that cost.

* In 2002, video on-demand began to grow. One company offered 430 movies for an average of $3 per rental.

* By 2002, several consumer-oriented articles argued that the late fees charged by Blockbuster would be enough to cover the cost of a Netflix subscription. Customers grew angry over the late fee prices.

* In 2002, Blockbuster responded directly to Netflix with three pricing plans. First, a customer could rent two videos at a time for $20 a month. Second, the customer could rent three videos at a time for $25 a month. In the third program, a customer could pay about $60 a year. This would allow the customer to keep three movies during the year without late fees, but the customer would have to pay for all movies rented. In the meantime, Netflix continued charging $20 to rent three movies at a time.

What do we learn from watching Blockbuster’s pricing over the years? During the 80s and 90s, Blockbuster was leading the industry on pricing. This was a double whammy for its competitors. It offered bigger, better stocked stores at lower prices than its competitors. But somewhere in the mid-90s, Blockbuster lost its edge. It decided that it had earned the right to have higher prices simply because it was the leader. Netflix continually beat Blockbuster on pricing. Red Box did the same thing with its $1 per night rental charges. Blockbuster was in a Leader’s Trap, and stayed in that unfortunate position for far longer than most industry leaders. (See the Perspective, “The Leader’s Trap” on StrategyStreet.com.)

Blockbuster engineered its own demise by failing to keep up with the performance of the new leaders in the industry, such as Netflix and Red Box, and by charging more than its competition for performance that failed to match theirs.

The Fall of an Industry Leader - Part 1

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Market Share Volatility in a Fast Growing Market

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

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

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

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

How Hostility Starts

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

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

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

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

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

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

P&G Takes Off the Gloves

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

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

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

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

A Pricing Scheme Guaranteed to Fail

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

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

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

The Kindle as a Razor

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

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

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

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

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

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

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

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

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

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

Apple's Future in Smart Phones - Part II

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

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

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

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

Apple's Future in Smart Phones - Part I

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

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

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

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

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

Discounts - Much Greater Than Most Assume

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

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

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

Service Levels Go Up, Not Down, in Hostility

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

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

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

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

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

Pricing in the Dog Days of August

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

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

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

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

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

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

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

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

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

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

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

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

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

Reliability in the Purchase Decision

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

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

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

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

Reliability in High-End Cars

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

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

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

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

The Decline of an Industry Leader

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

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

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

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

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

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

The Importance of Consistency in the Approach to Pricing

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

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

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

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

Pricing in Easy Industries

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

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

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

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

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

Situation Bad...About to Get Worse

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

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

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

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

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

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

Dis-Economies of Scale

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

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

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

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

What Happens When Giants Rumble

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

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

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

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

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

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