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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.