Benefits of Intense Competition: Lower Prices and Better Products

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

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

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

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

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

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

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

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

Cost Reduction by Redesigning the Product

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

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

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

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

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

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

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.

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.

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.

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.

Finding a Home for Orphaned Products

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

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

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

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

Here We Go Again

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

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

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

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

Mobile Hears Big Footsteps

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

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

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

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

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

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

More Steel Capacity. Why?

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

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

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

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

A Low-End Competitor with Low Industry Costs

Southwest Airlines is an unusual competitor. Since its inception, the company has been a low-end, discount competitor. What makes it an odd duck is that it provides service levels equivalent to the industry’s large legacy carriers while it also has very low costs compared to the industry’s erstwhile leaders, such as Delta, United and American Airlines. Southwest enjoys this low cost structure because it is less encumbered by onerous union work rules. Southwest has unionized employees, but their work rules are less restrictive than are those of the legacy airlines. Southwest uses this low cost structure to reduce prices and gain share against their larger legacy competitors. This has been going on for long enough that Southwest really is approaching industry leader status, if it’s not there already. Surely flying Southwest has become nearly as convenient and comfortable as flying one of the legacy airlines. The service of the legacy airlines has come to the level of Southwest, rather than the other way around.

Now Southwest has the economic where-with-all to do things that the poorer legacy airlines can not afford to do. For example, the company has made a major financial commitment to a new air traffic control system called “Required Navigation Performance” (RNP) routes. RNP is next generation technology that allows a flight to be less costly for the airline and more comfortable for passengers. (See the Symptom & Implication, “The industry is adding new, more efficient capacity in the effort to reduce costs” on StrategyStreet.com.) Airplanes can shorten their flights because they are able to use narrower and shorter descent patterns, reducing time and fuel. Passengers will find the descent more continuous, quieter and more comfortable.

This new technology will set Southwest back by $175 million. It put each of its pilots through ground school training on the new cockpit equipment and rewrote all of its flight procedures. Southwest made this investment on its own ahead of its competitors. The legacy carriers have delayed their own investments, hoping that the government will subsidize them. They can not afford this investment as easily as can Southwest. So, here we have a low-end competitor who has become an industry leader and continues to invest to reduce its operating costs and improve its performance for customers. (See “Video #46: The Place of Cost Management in Hostility” on StrategyStreet.com.) These investments slowly bleed away the advantages of the legacy carriers, adding to their economic strife.

There have been other low-end competitors who have been able to rise to industry leader status by taking advantage of the onerous work rules of their unionized competitors. The Japanese automobile manufacturers, especially Toyota, Honda and Nissan, certainly took that path. It appears that Hyundai is now following their lead in today’s automobile market.

Wal-Mart and the Customer Buying Hierarchy

Recently, Wal-Mart found that it was losing some customers to competitors. After examining the reasons why, the company discovered that some of its customers were leaving because Wal-Mart had eliminated some of the products the customers were used to buying at Wal-Mart. This situation gives us the opportunity to look at the Customer Buying Hierarchy in a retail business.

We use the Customer Buying Hierarchy to analyze a company’s competitive situation and to evaluate its product and service innovation program. Through thousands of customer interviews, we have seen that customers buy in a four part hierarchy: Function, Reliability, Convenience and Price. And customers buy in the order of the hierarchy. They first solve their Function problem. If they have not chosen a supplier, they then move to Reliability and then to Convenience and finally to Price. Most purchase decisions are made well before the average customer gets to Price. That’s hard to believe, but it is certainly the case.

What do these four terms mean? Function refers to the benefits that the user of the product enjoys. In a retail context, Function benefits include the set of products available for sale and the physical layout and amenities offered at the retail location. Reliability refers to the consistency with which the company delivers on its real or implied promises to its customers. A retail customer usually measures Reliability in terms of product stock-outs and customer service in the event that a product the customer buys does not work as promised. If the customer does not see that the retailer accepts returns for defective products, the customer will consider that retailer to have failed on Reliability. Convenience refers to the ease with which a customer may purchase the product. This is an important benefit in retail, and wholesale as well. A retail customer measures Convenience by the ease with which the customer is able to find the product he wants, chose among the various alternative products, and pay for the product. Finally, there is Price. The Price refers to the net cash costs that the customer must pay for the product, after consideration of all extra charges and discounts.

We have found that most companies actually have some customer purchases in each one of the four categories of the Customer Buying Hierarchy. A company like Wal-Mart will have more in Price than will a high-end company like Nordstrom. But even Nordstrom will have a few customers purchasing because of Price, often because of Price on a particular high-end product.

Wal-Mart has found that it was losing share to competitors. It was losing share because it was failing to offer the Function benefits that it had previously offered. To save costs, it withdrew products from its shelves (see the Perspective, “Achieving the Low-Cost Position” on StrategyStreet.com.) Then, some customers found they had to make a separate trip to another retailer to buy those products. It is worth noting that Wal-Mart lost relatively few customers. These customer losses had a relatively small impact on its market share. This tells us that there are probably relatively few customers who go to Wal-Mart primarily due to its Function benefits. None-the-less, Wal-Mart failed at Function and lost share, even though, for the majority of customers, it continued to be a winner on Reliability, Convenience and Price.

Hit Them on Both Sides of the Head

One of our local newspapers is running a series on the problems of public transportation in the San Francisco Bay Area. The problem seems to be that ridership is well off of plan. The economy, and its attendant reduction in jobs and squeeze on commuter pocketbooks, has reduced demand.

Virtually all of the authorities in charge of the various modes of public transportation have found the same magic elixir for this sickness. They plan to reduce services and raise prices at the same time. Let’s see now. We find that demand is off and our answer is to reduce what people can get for their money (offer less) and to charge them more to get that “less.” How is this likely to work? This will work only if the authorities can raise the prices enough to offset the likely accelerated loss in commuter revenues that the Price increase and Performance decrease is likely to bring.

Let’s use a few simple concepts to express better what is taking place. Any business offers a Value to its customers. The Value is a combination of the Performance the business offers the customer plus the Price the business charges. The Performance includes Benefits such as Features, Reliability and Convenience of purchase. The company must beat its competition in offering this Value in order to grow market share. Right now customers are telling public transportation authorities that the current level of service for the price charged is not high enough to keep all of them using public transportation.

The business supports its Performance with its Cost Structure. The company’s Cost Structure must allow the business to make a margin on the sale of the product to the customer. Here again, the business must have a Cost Structure at least as productive as that of its competition or its margins will be lower than those of the competition. Most of these public transportation authorities are losing money. They may not be less productive than direct competitors because there are so few of those kinds of competitors. However, they are less competitive than the consumer’s alternative, perhaps even the consumer’s own automobile.

A business in a loss position has negative margins. Costs are greater than revenues. The business has two levers to pull in order to get out of this situation, other than stringent cost reduction on the current Cost Structure. First, it may raise Prices and hope that the additional revenues on the customers who stay will be greater than the revenues lost by customers who leave due to the higher price. Second, it may reduce the Performance it offers the customer as well as the costs that support that Performance. As costs come down, margins may increase, as long as customers do not defect. In extreme situations, a business may raise Prices and reduce Performance at the same time.

How extreme is this radical approach of raising Prices and reducing Performance at the same time (gutting the former Value proposition)? Over the years we have evaluated thousands of Price increases. We have found that companies are able to raise Price and reduce Performance at the same time in about 3% of the cases where Prices rise in an industry. When you see this kind of an action, you can usually assume that the industry has very strong pricing power. (See the Perspective, “Who Has Pricing Power?” on StrategyStreet.com.) For example, HP and Lexmark International launched lower capacity ink cartridges with smaller price tags to try and counter the growth of off-brand printer ink sellers. These cartridges had starting prices below $15 a cartridge but their cost per ounce of ink was higher than the predecessor products. In another case, the cable T.V. industry for years prospered by raising prices well in excess of inflation at the same time as forcing consumers to buy packages of channels, including many channels the customers did not want or ever use.

Occasionally, you also see the phenomenon of a raised Price and decreased Performance in an act of desperation to save the business. (See the Symptom & Implication, “New competition is entering a settled market” on StrategyStreet.com.) The airline industry has begun charging for previously free services, such as checking bags and serving onboard meals at the same time that its prices have gradually risen. The legacy airlines may have no choice. The difference, in this case, is that the airline industry is operating at higher levels of utilization and actually has a bit of pricing power today. Newspaper publishers have raised prices and reduced coverage in their print products to stay alive. The outlook for public transportation, and some other industries in desperate need, such as newspapers, is grim.

Acquisitions to Gain Product Capability

There are three primary reasons to make an acquisition. First, the acquirer may use the acquisition to reduce its cost by consolidating and reducing the total cost of overlapping cost functions. Second, the acquirer may seek to gain a new set of customers. And, third, the acquirer may be seeking a product capability which it does not have. In general, we believe that a successful acquisition will meet at least two out of these three criteria.

Recently, both Apple and Google have made important acquisitions. (See “Audio Tip #104: Where is the “Profit” in Expansion?” on StrategyStreet.com.) Both of these acquisitions have the bonus of acquiring a product capability that the company needs. Google acquired AdMob, a company which places ads on mobile web sites and applications. This is a very fast-growing market. Apple, shortly afterwards, followed suit by acquiring Quattro Wireless, a smaller competitor of AdMob. Google needs this acquisition in order to extend its advertising expertise into the mobile market. Apple needs its acquisition in order to make some revenues on the many free apps that run on its iPhones.

Which of the two companies is likely to be more successful in its acquisition? (See “Audio Tip #200: Using Acquisitions to Create Economies of Scale” on StrategyStreet.com.) Apple should certainly be able to generate revenue relatively quickly because there are so many free apps already out for the iPhone, which run on an advertising business model where the app is free to the consumer. On the other hand, Apple’s culture is hardware oriented. The company may have difficulties in dealing in a largely service-oriented market.

That won’t be Google’s problem. It already lives in the advertising world. In addition, AdMob is a much larger company than is Quattro. Google is likely to have acquired a new product capability with a lower cost structure than its Apple/Quattro Wireless competitor.

A Pyrrhic Victory?

Wal-Mart stores and Costco Wholesale are disrupting markets again. The market they are disrupting today is the grocery industry. In truth, they have been disrupting the grocery industry for the last several years, to the point that Wal-Mart is now the largest grocery store company in the country. These two competitors drain their competition of their life blood by using low prices. The recession, along with the pressure applied by Wal-Mart and Costco, has reduced the consumer pricing index for food by nearly 3% over the last year.

So, what is an industry leader to do when faced with the Wal-Mart challenge? Kroger answered right away. The company reduced its prices along with those of Wal-Mart. (See “Audio Tip #180: The Real Low-Cost Competitor” on StrategyStreet.com.) The result is that Kroger expanded its market share. This growth in market share came at the expense of other industry leaders, such as Safeway and Supervalu, who did not cut their prices as deeply. (See the Symptom & Implication “As large competitors match low prices, other competitors face difficulties” on StrategyStreet.com.)

There is a rub, of course. Kroger’s margins declined in the face of the price deflation. Predictably, Wall Street pummeled Kroger’s stock.

Wall Street is wrong here. In the long term, the increase in Kroger’s size will enable it to reduce its cost structure compared to that of its smaller rivals. The easiest way to reduce a cost structure is when the company’s sales aren’t growing and you can find opportunities to improve the productivity of the cost structure by increasing efficiency and effectiveness. (See “Audio Tip #196: Why Economies of Scale Exist” on StrategyStreet.com.) It is much harder to reduce costs when the business is shrinking. In a shrinking business, company morale tends to be bad and companies almost inevitably cut muscle as well as fat.

A growing business will also allow Kroger to fine tune its value proposition in the face of the Wal-Mart price challenge. The customer buys Function, Reliability and Convenience before Price. Kroger’s ability to tailor its offerings for a broad swath of customers, and its local presence, are powerful advantages, even in the face of a competitor with lower prices. (See “Video #56: Design to Value as an Approach to Cost Management” on StrategyStreet.com.) Kroger is right.

Divorce that Customer?

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

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

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

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

One Up, One Down, One Sideways

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

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

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

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

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

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

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

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

Let Someone Else Pay the Freight

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

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

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

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

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

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

Digits Save Lives...and Costs by Improving Effectiveness

Part 2

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Digits Save Lives...and Costs by Improving Efficiency

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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