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.

Failures in Reliability Lead to Share Loss

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

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

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

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

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

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

The Mobile Phone Industry and Customer Retention

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

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

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

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

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

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

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

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

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

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




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



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



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

Constrictions in Components Supply Support Higher Prices

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

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

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

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

Strangling the Goose

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

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

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

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

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.

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.

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.

No Red Letter Day for BlueStar

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

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

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

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

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

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

Using Finance to Reduce a Price

Dell is struggling to keep up with HP in the personal computer market. There is one part of the market, though, where Dell remains the clear leader, the small business market. Part of the reason for the company’s success in this market is its financing package. It is more generous with financial support than its competition. It may offer interest-free financing when companies purchase $25,000 or more of new computers. The company offers other creative financing deals. In one of these deals, a customer bought $30,000 of computers on a three-year lease plan that allows the customer to keep the equipment when the lease expires. Overall, Dell says that 22% of its small and medium-size business customers use Dell to finance their purchases. This 22% is up from 17% just two years ago. The company is gaining share by using its financing muscle, despite the chancy economic environment.

Offering financing, whether subsidized or not, is a way of extending the time a customer has to make its cash payment to the supplier. This is a form of discount. In our analysis of several thousand price reductions over the last twenty-five years, we have identified fifteen distinct forms of discount. The offering of financing is one of those forms. Many industries have relied on financing to build their businesses, even in difficult times. The automobile industry has used financing to offer attractive lease rates and payment plans to its customers using captive finance vehicles, like GMAC. GE has used its captive finance arm to finance customers in many of its product categories. In fact, GE has seen its captive finance arm grow into a lender in many markets where GE does not even compete as a supplier.

The home building industry has also used financing creatively. For example, last year Lennar offered special financing with no money down and a 3.625% mortgage rate for the life of its loans on purchases of Lennar’s newly built homes. Subsidized financing helped Lennar win new customers in an abysmal market. (See the Symptom & Implication, “Demand in the industry is falling” on StrategyStreet.com.)

Even small businesses use the extension of financing to build their businesses. Faryl Robin is a New York company that sells high-end women’s shoes. In the expectation that it would build its business with long-time customers in a tough economy, the company offered additional financing. In 2009, it offered retail customers with whom it had a long-term relationship an additional sixty days over its normal thirty day payment period for the customer to make its full payment for shoes she had purchased.

Yep, Those Germans are the Problem

There has been much press over the last few weeks about the problems in the Euro Zone. Most particularly, we have learned more than we may want to know about the problems of deficit spending in Greece, Spain, Ireland and Portugal. Just recently, though, we may have learned that the problem is not the deficit spending in those recessionary countries. No, the problem seems to be the Germans.

Over the last ten years those nasty Germans have kept the lid on labor cost growth and have jacked up their rates of productivity. (See the Symptom & Implication, “Some competitors automate to become the lowest cost players” on StrategyStreet.com.) These simple actions have enabled Germany to compete on price despite high labor rates and competition from countries in the Euro Zone with nominal lower labor costs. Oh, those countries include Greece, Spain, Ireland and Portugal. Those inconsiderate Germans have produced a Euro 136 billion trade surplus in 2009. Spain, Greece and Portugal ran significant deficits. The Finance Minister of France has suggested that Germany’s export dependent growth model may be causing a lot of the problem in the Euro Zone. Her answer to this problem is for Germany to begin spurring domestic demand. So we see that the problem in the Euro Zone is people who do not deficit spend and who take advantage of all their poorer neighbors who do deficit spend.

This is causing turmoil in the Euro Zone that, in the long run, is almost certainly bad for the Euro. Some countries might have to exit the Euro Zone. Greece has threatened to use IMF resources to continue its deficit spending. The economic disunity in the Euro Zone is creating political disunity as well. There is a question whether the Euro Zone can continue in its present form.

We have similar situations among the states in the United States. The differences are that the states can not threaten to withdraw from the Dollar Zone, nor are they eligible for IMF financing. Our deficit financing states tend to be those with the highest labor costs. As a result, the unemployment rate in these states is higher, often much higher, than that in the country as a whole. In January of 2010, the United States national unemployment rate, as reported by the Bureau of Labor Statistics, showed an average of 10% unemployment in the country. The highest unemployment occurred in Michigan, with a 14.3% rate. Other high unemployment states included Rhode Island, California, Illinois and Ohio. In many of these states, labor costs are not only high, but they are inflexible. Companies can not change work rules, nor adjust rates of labor, to match the current economy. That’s part of the reason that jobs flee these states.

In the Euro Zone, German workers have wages and benefits among the highest in Europe. They average Euro 34 an hour, roughly $48 an hour. Recently, the German Metal Workers Union accepted a new contract with very low wage growth in order to protect their jobs in Germany.

Here is a contrast for you. In 2008, the average worker for the “Big Three” automakers earned $73 an hour in total compensation. Workers at Toyota, and other foreign makers, earned an average of $48 in their U.S. operations. These companies have located their U.S. plants in areas where labor is more flexible. The average U.S. manufacturing worker earned something less than $32 an hour in 2008. These labor cost disparities help us understand how Detroit is losing population. Nearly a quarter of its manufacturing jobs have left. The city suffers from a 50% unemployment rate. Detroit’s woes certainly have contributed to Michigan’s nation-leading 14.3% unemployment rate. But isn’t some of this woe self-inflicted? Why can’t domestic automakers make cars in the U.S. for $48 an hour?

The German unions have learned that they can sustain their high rates of pay only so long as they help their companies become more productive with every hour of labor. The workforce shares a large portion of the improvement in productivity. (See “Audio Tip #187: The Components of Productivity” on StrategyStreet.com.) Apparently, at least one of our leading labor unions does not share that calculus.

Meeting a Challenge from Below

Boeing and Airbus have an interesting problem. These two companies had been sparring back and forth for several years in the large plane market. The industry’s largest customers, such as United and Republic Airways Holdings, are among the most important customers for the large planes and thus for Boeing and Airbus.

Recently, though, a new set of challengers has entered the lists. The two most important of these challengers are Canada’s Bombardier, Inc. and Brazil’s Embraer. These new challengers are much smaller companies. (See the Symptom & Implication, “Demand continues to grow but margins are low and new entrants are taking share” on StrategyStreet.com.) They also build smaller airliners with shorter ranges than Boeing’s 737 and Airbus’ A320. Normally, these smaller competitors would sell to the industry’s smaller regional airlines.

These new competitors, though, have offered something new and attractive. The new companies are each offering a 150 seat jetliner with 15% better fuel economy compared to current 737s and A320s. Now customers, including United and Republic, are demanding that Boeing and Airbus produce a plane with an equivalent savings.

But this is a problem for the leaders. After years of jostling back and forth for market share and industry leadership, the industry leaders’ margins on airliner sales are low, even though there are only two competitors fighting this price war. (See the Perspective, “What Ends Hostility?” on StrategyStreet.com.) Last year, Boeing had an operating profit of about 3% on $68 billion in sales. The price wars have indeed been tough. Furthermore, the company has only $2 billion in equity to support $62 billion in total assets. Things aren’t quite as bad as that may sound because about $11 billion of those assets are cash and equivalents. Still, the company’s margin for safety is relatively thin.

Now you can understand how Embraer and Bombardier were able to come up with new, cheaper, technology in the small jetliner market. They have been earning better profits selling to regional airlines. Both Boeing and Airbus had hoped to wait several more years before updating their small airliners, but the customers won’t stand for it. Instead, both of the larger companies seemed poised to improve the fuel economy of their 737s and A320s by changing the engine configuration as a way of updating and improving the jetliner’s efficiencies. This should close part of the 15% fuel economy gap, but not all of it.

It appears that the industry’s smaller, lower-end, competitors are in for a few good years. The industry leaders simply don’t have the resources to stop them in the near term. We’ll see something similar in the next blog, though the reasons for the success of the lower-end competitor is less in resources and more in will.