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In the remainder of this note, we employ an activity template, the value chain, that can guide managers in breaking down the firm into activities.²² The value chain divides all activities into two classes: primary activities that directly generate a good or service, and support activities that make the primary activities possible. Primary activities are broken down further into inbound logistics, operations, outbound logistics, marketing and sales, and after-sales service. Support activities include procurement of inputs, development of technology and human resources, and general firm infrastructure. Figure 6 shows the value chain of an Internet start-up that sells compact discs online and ships them by mail to customers.

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Conclusion

This note has covered a lot of ground, but the main ideas are fairly simple:

! A successful firm does not simply participate in an attractive industry. It also strives to generate more economic profits than the typical firm in its industry.

The ability to generate and capture profits in an industry derives from added value. A firm has added value when the network of customers, suppliers, and complementors in which it operates is better off with the firm than without it; the firm offers something that is unique and valuable in the marketplace.

A firm usually can’t claim any value unless it adds some value.

To have added value, a firm must drive a wedge between customer willingness to pay and supplier opportunity cost—indeed a wider wedge than rivals achieve. A firm that attains a wider wedge is said to have a competitive advantage.

To establish a competitive advantage, a firm has to do different things than its rivals on a day-to-day basis. These differences in activities, and their effects on relative cost and relative willingness to pay, can be analyzed in detail.

A firm can use its analysis of activities to generate and assess options for creating competitive advantage. In doing so, the management team must decompose the firm into parts, but also craft a vision of an integrated whole.

The landscape metaphor reminds us that the creation of competitive advantage involves choice. In occupying one peak, a firm foregoes an alternative position. It also highlights the role of competition: it is often more valuable to inhabit one’s own, separate peak than to crowd onto a summit that is already heavily populated. Finally, it emphasizes the importance of internal consistency. Peaks are coherent bundles of mutually reinforcing choices.

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The Whole Versus the Parts

The analysis we have described focuses on decomposing the firm into parts—discrete activities. In the final step of exploring options, however, the management team must work vigilantly to build a vision of the whole. After all, competitive advantage comes from an integrated set of choices about activities. A firm whose choices are internally inconsistent is unlikely to succeed.

We have found a landscape metaphor helpful to describe the dilemma facing managers who are searching for a favorable set of choices.³⁸ In conceptual terms, the managers of a firm operate in a high-dimensional space of decisions. Each point in this space represents a different set of choices, a different configuration of activities.

The elevation corresponding to each point is the added value generated by that configuration. The goal of the senior management team is to guide its firm to a high point on this landscape—a set of decisions that, together, generate a great deal of added value.

The search for high ground is made difficult by the fact that the different choices interact with one another: production decisions affect marketing choices, distribution choices need to fit with operations decisions, compensation choices influence a whole range of activities, and so forth.

Each interaction implies that a choice made on one dimension affects the cost and willingness-to-pay impact of another choice. Graphically, the interactions make the surface of the landscape rugged with lots of local peaks.

The ruggedness of the landscape has a couple of vital implications. First, it suggests that incremental analysis and incremental change are unlikely to lead a firm to a new, fundamentally higher position. Rather, a firm must usually consider changing many of its activities in unison in order to attain a higher peak. To improve its long-run prospects, a firm may have to step down and tread through a valley.

(Consider the wrenching and far-reaching changes required to turn around IBM during the mid-1990s.) Second, the ruggedness implies that there is often more than one internally consistent way to do business within an industry.

There is certainly only a limited number of viable positions, but when the interactions among choices are rich, there is usually more than one high peak. In the retail brokerage business, for instance, both Merrill Lynch and Edward Jones succeed, but they do so in very different ways.

Merrill Lynch operates large offices in major cities, provides access to a full range of securities, advertises nationally, offers in-house investment vehicles, and serves corporate clients. Edward Jones operates thousands of one-broker offices in rural and suburban areas, handles only conservative securities, markets by means of door-to-door sales calls, produces none of its own investment vehicles, and focuses almost exclusively on individual investors.³⁹ The two firms occupy quite different peaks on the landscape of the financial services industry.

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Step 4: Explore Options and Make Choices

The final step in the analysis of cost and willingness to pay is to search for ways to widen the wedge between the two. The management team has the machinery in place to understand how changes in activities will affect competitive advantage.

The goal now is to find favorable options. The generation of options is ultimately a creative act, and it is difficult to lay down many guidelines for it. We can, however, suggest a few patterns from past experience:

! It is often helpful to distill the essence of what drives each competitor. Betsy Baking, for instance, saw that preservatives were a substitute for fast delivery. By adding preservatives to its physical product, it could reduce its delivery costs substantially.

This also reduced customers’ willingness to pay, but the reduction was smaller than the corresponding cost savings for many customers. Such a distillation process often suggests new ways to drive wedges. Savory Pastries, for instance, was tapping a willingness to pay for freshness.

The Collins managers, however, felt that Savory was not exploiting this customer need fully; a product even fresher than Savory’s might command a large premium, and this might be the basis for a substantial competitive advantage.

! When considering changes in activities, it is crucial to consider competitor reactions. In the snack cake example, the Collins managers felt that Betsy Baking would readily launch a price war against any competitor that tried to match its low-cost, low-price strategy. They were less concerned about an aggressive response from Savory Pastries, whose managers were distracted by an expansion into a different business.

! In crafting alternatives, managers tend to fixate on physical product characteristics and think too narrowly about benefits to buyers. Rarely do they consider the full range of ways in which all of their activities can create a wedge between willingness to pay and costs. One way to avoid a narrow focus is to draw out not only one’s own value chain, but also the value chains of one’s customers and suppliers and the linkages between the chains.³⁴

Such an exercise can highlight ways to reduce buyers’ costs, improve buyers’ performance, reduce suppliers’ costs, or improve suppliers’ performance. Some apparel manufacturers, for instance, have found new ways to satisfy department store buyers, ways that have nothing to do with the physical character of the clothes. By shipping clothes on the proper hangers and in certain containers, the manufacturers can greatly reduce the labor and time required to get clothes from the department store loading dock to the sales floor.

! In rapidly changing markets, it is often valuable to seek options by paying special attention to “bleeding edge” customers—exacting customers whose demands presage the needs of the larger marketplace. Yahoo!, the Internet portal, releases test versions of new services to sophisticated users in order to shake down software and sense the future needs of the wider market.³⁵

Similarly, underserved customer segments often point the way to creative alternatives. Circus Circus, the casino operator, built much of its remarkable success in the early 1990s on the insight that Las Vegas offered little to the family-oriented segment of the market. And the Southwest example reminds us that overserved customers can offer an opportunity as well.

! More generally, one of the most potent ways that a firm can alter its wedge between willingness to pay and costs is by adjusting the scope of its operations—that is, changing the range of customers it serves or products it offers within an industry.

Broad scope in an industry tends to be advantageous when there are significant economies of scale, scope, and learning (including vertical bargaining power based on size), when customers’ needs are relatively uniform across market segments, and when it is possible to charge different prices in different segments. Of course, broader isn’t always better: there may be diseconomies rather than economies of size, and attempts to serve heterogeneous customers may introduce compromises into a firm’s value chain or blur its external or internal message by creating cognitive conflicts in the minds of customers or employees.³⁶

And even when broader is better, there tend to be a variety of ways in which a firm can expand its reach, some of which (such as licensing, franchises, or strategic alliances) fall short of an outright expansion of scope.

! Here, we have laid out a process in which a management team develops a comprehensive grasp of how its activities affect costs and willingness to pay, then considers options to widen the wedge between the two.

In practice, it is often efficient and effective to reverse this process: to start with a set of options, articulate what each option implies for activities, then analyze the impact of each alternative configuration of activities on the wedge between costs and willingness to pay.

By reverse-engineering the analyses they do from the options they have, managers can focus on the analyses that truly matter. Of course, this alternative process works best when managers start with a good grasp of the options available to them.³⁷

In general, a firm should scour its value chain for, and eliminate, activities that generate costs without creating commensurate willingness to pay. It should also search for inexpensive ways to generate additional willingness to pay, at least among a segment of customers.

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Step 3: Use Activities to Analyze Relative Willingness to Pay

The activities of a firm do not just generate costs. They also (one hopes) make customers willing to pay for the firm’s product or service. Differences in activities account for differences in willingness to pay and hence for competitive advantage and differences in profitability. In general, it appears that differences in willingness to pay account for more of the variation in profitability observed among competitors than do disparities in cost levels.²⁶

Virtually any activity in the value chain can affect customers’ willingness to pay for a product.²⁷ Most obviously, the product design and manufacturing activities that influence physical product characteristics—quality, performance, features, aesthetics, durability—affect willingness to pay.

Consumers pay a premium for New Balance athletic shoes in part because the firm offers durable shoes in hard-to-find sizes. In fact, by avoiding deals with superstar athletes and publicizing that its shoes are “endorsed by no one,” New Balance actively emphasizes to consumers that they should pay attention only to the physical characteristics of its shoes.

More subtly, a firm can boost willingness to pay through activities associated with sales or delivery—the ease of purchase, speed of delivery, availability and terms of credit, convenience of the seller, quality of presale advice, etc.

In the 1990s, for example, the catalog florist Calyx and Corolla commanded a premium because it delivered flowers faster and fresher than most competitors did.²⁸

Activities associated with post-sale service or complementary goods—customer training, consulting services, spare parts, product warranties, repair service, compatible products—also affect willingness to pay. For example, American consumers may hesitate to buy a Fiat automobile because they fear that spare parts and service will be hard to obtain.

Signals conveyed through advertising, packaging, branding efforts, etc. also play a role in determining willingness to pay. Nike’s advertising and endorsement activities, for instance, affect the premium it commands. Finally, support activities can have a surprisingly large, if indirect, impact on willingness to pay. The hiring, training, and compensation practices of Nordstrom create a helpful, outgoing sales staff that permits the department store to charge a premium for its clothes.

Ideally, a company would like to have a “willingness to pay calculator”—something that tells it how much customers would pay for any combination of activities. For a host of reasons, however, such a calculator is virtually always beyond a firm’s grasp.

Willingness to pay often depends heavily on intangible factors and perceptions that are hard to measure. Moreover, activities can affect willingness to pay in complicated (i.e., nonlinear and non-additive) ways. And when a business sells to end-users through intermediaries rather than directly, willingness to pay depends on multiple parties.

Lacking a “willingness to pay calculator,” most managers who analyze relative willingness to pay do so in a simplified manner. A typical procedure is as follows. First, the managers think carefully about who the real buyer is.   This can be tricky.   In the market for snack cakes, for instance, the immediate purchaser is a supermarket or convenience store executive. The ultimate consumer is typically a hungry school child. But the pivotal decision maker is probably the parent who chooses among the brands.

Second, the managers work to understand what the buyer or buyers want. The snack cake-buying parent, for example, selects among brands on the basis of price, brand image, freshness, product variety, and the number of servings per box.²⁹

The supermarket or convenience store executive chooses a snack cake on the basis of trade margins, turnover, reliability of delivery, consumer recognition, merchandising support, and so forth.

Marketing courses discuss ways to pinpoint such customer needs and desires through formal or informal market research.³⁰ It is important that such research identifies not only what customers want, but also what they are willing to pay for. Moreover, the research should reveal what the most important needs are and how customers make trade-offs among different needs.

Third, managers assess how successful they and competitors are at fulfilling customer needs. Figure 9 shows such an analysis for the snack cake market. The analysis helps us understand both the statics and the dynamics of the marketplace.

Betsy Baking stands out on an attribute that customers value highly, low price, while Collins is superior on none of the customer needs. This helps us understand the large shifts in market share. Ontario Baking enjoys the best brand image—a position it has paid for via relatively heavy advertising and promotion. (See Figure 8.)

Savory Pastries delivers the freshest product, reflected in its high manufacturing and raw materials cost. Further analysis, not carried out in the snack cake example, can assign dollar values to the customer needs. For example, it can estimate how much a customer will pay for a product that is one day fresher.

Fourth and finally, the managers relate differences in success in meeting customer needs back to activities. Savory Pastries’ high score on the freshness need, for instance, can be tied directly to specific activities regarding procurement and selection of ingredients, manufacturing, and delivery.

At this point, managers should have a refined idea of how activities translate, through customer needs, into willingness to pay.

They also understand how activities alter costs. Now they are prepared to take the final step, the analysis of different strategic options. Before we move on to that step, however, we should highlight some guidelines concerning the analysis of willingness to pay.

A major challenge in analyzing willingness to pay is narrowing the long list of customer needs down to a manageable roster. In general, needs that have little effect on customer choice can be ignored.

Needs that are equally well satisfied by all current and contemplated products can usually be neglected. If the group of competing products plays a small role in satisfying a need relative to other products outside the group, the need can often be removed from the list.

So far, we have treated all customers as identical. In reality, of course, buyers differ in what they want and how badly they want it. Some customers in a bookstore want novels while others look for business books. (This type of disparity, in which different customers rank products differently, is known as horizontal differentiation.)

Among those customers who want J.K. Rowling’s new Harry Potter novel, some are willing to pay for the hardback edition sooner while others will wait for the less expensive soft-cover version. (Vertical differentiation arises when customers agree on which product is better—the hardback edition, now—but they differ in how much they will pay for the better product.)

The analysis of willingness to pay is trickier, but more interesting, when customers differ in their preferences. The usual response is segmentation: one first finds clumps of customers who share preferences and then analyzes willingness to pay segment by segment.

In our experience, firms that identify segments pinpoint between two and twelve clusters of customers. The more diverse are customer needs and the cheaper it is to customize the firm’s product or service, the more segments a firm typically considers. Some observers have even argued that companies should move beyond segmentation to embrace mass customization.³¹

In this approach, enabled by information and production technologies, companies begin to tailor their products to individual customers. Thus, Blinds to Go receives up to 20,000 custom orders for window blinds and shades per day, and it promises to process each order within 48 hours. New approaches to customization have enabled it to build up a business with more than $100 million in revenues and 20% net margins.³²

Finally, we want to emphasize the limits to analyzing willingness to pay. In some settings, it is possible to quantify willingness to pay quite precisely. For example, when a firm provides an industrial good that saves its customers a well-understood amount of money, it is relatively easy to calculate willingness to pay. (Think of the Harnischfeger example.)

Calculations are much more difficult, however, when there is a large subjective component to buyer choice, when customer tastes are evolving rapidly, and when the benefits the customer derives from the product are hard to quantify. A wide range of market research techniques—surveys, hedonic pricing, attribute ratings, conjoint analysis, etc.—are designed to overcome such problems.

We remain leary, however, especially when the market research asks people to assess their willingness to pay for new products that they have never seen or for the satisfaction of needs that they themselves may not realize they have. Fine market research “proved” that telephone answering machines would sell poorly, for instance.³³ In some settings, creative insight may have to replace analysis. In all settings, analysis should serve to hone insight, not displace it.

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Step 2: Use Activities to Analyze Relative Costs

Competitive cost analysis is the usual starting point for the strategic analysis of competitive advantage. In pure commodity businesses such as wheat farming, customers refuse to pay a premium for any company’s product. In such a setting, a low-cost position is the key to added value and competitive advantage. But even in industries that are not pure commodities, differences in cost often wield a large influence on differences in profitability.

Cost analysis was one of the efforts that managers at Collins Kitchens undertook in the mid-1990s as they struggled to understand why their financial performance was poor and their market share plummeting. They cataloged the major elements of their value chain and calculated the costs associated with each class of activities. As Figure 7 shows, although Collins sold the typical package of snack cakes to retailers for 72¢, raw materials (ingredients and packaging material) accounted for only 18¢ per unit. Operation of automated baking, filling, and packaging production lines, largely depreciation, maintenance, and labor costs, amounted to 15¢.

Outbound logistics—delivery of fresh goods directly to convenience stores and supermarkets, and maintenance of shelf space—constituted the largest portion of costs, 26¢. Marketing expenditures on advertising and promotions added another 12¢. A mere penny remained as profits for Collins.

The managers then determined the set of cost drivers associated with each activity. Cost drivers are the factors that make the cost of an activity rise or fall. For instance, the managers realized that the cost of outbound logistics per snack cake fell rapidly as a firm increased its local market share; total delivery costs depended largely on the number of stops that a truck driver had to make, and the larger was a firm’s market share, the greater was the number of snack cakes a driver could deliver per stop.

Urban deliveries tended to be more expensive than suburban because city traffic slowed down drivers. Outbound logistics costs also rose with product variety; a broad product line made it difficult for drivers to restock shelves and remove out-of-date merchandise. Finally, the nature of the product affected logistics costs: snack cakes with more preservatives could be delivered less frequently. The managers developed numerical relationships between activity costs and drivers, for outbound logistics activities and for the other activities in Figure 7.

Cost drivers are critical because they allow managers to estimate competitors’ cost positions. One usually cannot observe a competitor’s costs directly, but one can often observe the drivers. One can see, for instance, a competitor’s market share, the portion of its sales in urban areas, the breadth of its product line, and the ingredients in its products. Using its own costs and the numerical relationships to cost drivers, a management team can estimate a competitor’s cost position.

When Collins’ managers did this for Betsy Baking, they found the results sobering. Because Betsy Baking used inexpensive raw material, purchased in bulk, and tapped national scale economies, its operations costs totaled 21¢, in contrast to 33¢ for Collins. Betsy Baking packed its product with preservatives so that deliveries could be made less frequently, kept its product line very simple, and benefited from growing market share. Consequently, its logistics costs per unit were less than half of Collins’.

Also, Betsy Baking did not run promotions. Altogether, the managers estimated, a package of Betsy Baking snack cakes cost only 34¢ to produce, deliver, and market. Comparisons with the two other major competitors, Ontario Baking and Savory Pastries, were not so discouraging. Indeed, Collins had a small cost advantage over each. (See Figure 8.)

This specific example illustrates a number of general points about relative cost analysis:²³

• When reviewing a relative cost analysis, it is important to focus on differences in individual activities, not just differences in total cost. Ontario Baking and Savory Pastries, for instance, had similar total costs per unit. The two firms had different cost structures, however, and as we will discuss below, these differences reflected distinct competitive positions.

Good cost analyses typically focus on a subset of all of a firm’s activities. The cost analysis in Figure 8, for example, did not cover all the activities in the snack cake value chain. Effective cost analyses usually break out in greatest detail and pay the most attention to cost categories that (1) pick up on significant differences across competitors or strategic options, (2) correspond to technically separable activities, or (3) are large enough to influence the overall cost position significantly.

•         Activities that account for a thicker slice of costs deserve deeper treatment in terms of cost drivers. For instance, the snack cake managers assigned several cost drivers to outbound logistics and explored these drivers in depth. They spent little time considering the drivers of advertising costs. The analysis of any cost category should focus on the drivers that have the biggest impact on it.

•         A particular driver should be modeled only if it is likely to vary across the competitors or the strategic options that will be considered. In the snack cake example, manufacturing location influenced wages rates and therefore operations costs. All of the rivals manufactured their snack cakes in western Canada, however, and manufacturing elsewhere was not an option because shipping was costly and goods had to be delivered quickly. Consequently, manufacturing location was not considered as a cost driver.

•         Finally, since the analysis of relative costs inevitably involves a large number of assumptions, sensitivity analysis is crucial. Sensitivity analysis identifies the assumptions that really matter and therefore need to be honed. It also tells the analyst how confident he or she can be in the results. Under any reasonable variation of the assumptions, Betsy Baking had a substantial cost advantage over Collins.

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A number of references discuss cost drivers in greater detail and suggest specific ways to model them numerically.²⁴ The catalog of potential drivers is long. Many relate to the size of the firm: economies of scale, economies of experience, economies of scope, capacity utilization, etc. Others relate to differences in firm location, functional policies, timing (e.g., first-mover advantages), institutional factors such as unionization, government regulations such as tariffs, and so forth. Differences in the resources possessed by a firm may also drive differences in activity costs. A farm ^ with more productive soil, for instance, will incur lower fertilization costs.

A number of pitfalls commonly snare newcomers to cost analysis. Many companies, particularly ones that produce large numbers of distinct products in a single facility, still have grossly inadequate costing systems that must be cleaned up before they can be used as reference points for estimating competitors’ costs.   

As courses on management accounting point out, conventional accounting systems often overemphasize manufacturing costs and do a poor job of allocating overhead and other indirect costs. As firms increasingly sell services and transact on the basis of knowledge, these outdated systems make it harder and harder to analyze costs intelligently.²⁵

Also problematic is a tendency to compare costs as a percentage of sales rather than in absolute dollar terms. This confounds cost and price differences. It is also common, but dangerous, to mix together recurring costs and one-time investments.

Some analysts confuse differences in firms’ costs with differences in their product mixes. One can avoid this problem by comparing the cost positions of comparable products; compare Ford’s four-cylinder, mid-sized family sedan to Toyota’s four-cylinder, mid-sized family sedan, not some imaginary “average” Ford to some “average” Toyota. Finally, a focus on costs should not crowd out consideration of customer willingness to pay—the topic of the next section.

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Step 1: Catalog Activities (The Value Chain)

In the remainder of this note, we employ an activity template, the value chain, that can guide managers in breaking down the firm into activities.²² The value chain divides all activities into two classes: primary activities that directly generate a good or service, and support activities that make the primary activities possible. Primary activities are broken down further into inbound logistics, operations, outbound logistics, marketing and sales, and after-sales service. Support activities include procurement of inputs, development of technology and human resources, and general firm infrastructure. Figure 6 shows the value chain of an Internet start-up that sells compact discs online and ships them by mail to customers.

Once activities have been cataloged, they must be analyzed in terms of cost and willingness to pay relative to the competition. To illustrate how this is done, we focus on a simple example: the snack cake market in the western region of Canada.^* Between 1990 and 1995, Betsy Baking grew its share of this market from a meager 1% to nearly 20%. At the same time, Collins Kitchen, the maker of such long­time favorites as Dinklets and Angel Dogs, saw its dominant 45% share dwindle to 25%. An analysis of relative costs and willingness to pay shows why Betsy Baking and Collins fared so differently.