1. 1 Creating and capturing value MBA 299: Strategy Ian Larkin & Evan Rawley 4-8-2004

2. 2 Agenda CSG update Introduction to today Value creation frameworks

3. 3 Update on CSG Round 3 has been turned in; results posted later today Only one round due next week: Round 4 by noon on Tuesday, April 12 Round 5 due by noon Monday, April 18  Critical re-investment round! Will discuss in section next week Round 5 strategy memo due in class on Monday

4. 4 Strategy memos Some of the round 1 strategy memos were very good; others showed a lack of effort Most focused very heavily on costs instead of other potentially important topics, and were quite static. Important topics:  Market dynamics (importance of different cost drivers, likely pricing, etc)  Competitive dynamics – anticipating likely competitor moves (or scenarios) and how this will affect (or has affected) your strategies  Both of these, especially the latter, are very important for the remaining 2 memos Note: this should be a “mini case write-up”; as such, long lists of bullet points, a lack of organization, no topic sentences, etc, are all negatives  Write an organized memo, not a list of talking points!

5. 5 Where are we in the CSG? Important questions to think about at this point:  Since most markets haven’t yet reached an equilibrium…. What equilibrium are you hoping for? What other possible equilibria are out there? What levers do you have to get to this equilibrium?  Price is not your only lever…..  Given where the markets are today, are you on a path to make money? How much? Are you satisfied with this? Given 2 rounds of selling, what do your ACTUAL average costs look like? How does this compare with your initial plans?

6. 6 Agenda CSG update Introduction to today Value creation frameworks

7. 7 Introduction to today’s topic A recurring question in the cases is how well positioned a company is to capture profits  Industry analysis (a la Porter) is part of the story, but even within industry, there is a wide variation in profitability Today’s discussion is about different frameworks researchers in strategy use to talk about whether and how a firm can sustain profits, given industry characteristics  Cost/differentiation framework  Core competencies framework  Value-net framework  Vertical integration frameworks

8. 8 Agenda Cost/differentiation framework Core competencies framework Value-net framework Vertical integration framework

9. 9 Two generic sources of competitive advantage – 3 rd dimension is degree of focus Low cost – focus on operations  Essential in a commodity business but can work in almost every business Ruthlessly efficient/lean – Dell, Ryanair, CCS High scale/utilization – Beer giants Highly differentiated – focus on unique quality  Strong brand - Coke  IP protected product – Pharmaceuticals  Selecting good customers – Progressive

10. 10 Many types of cost advantages General drivers of cost advantages  Economies of scale or scope  Capacity management/utilization  Cumulative experience (learning curve)  Transaction cost advantages (vertical integration, long-term contracting)  Location  Access to better input prices

11. 11 Many types of differentiation possible General drivers of differentiation  Physical characteristics of the product (size, shape, features, color, durability, ease of use…)  Quality of complementary goods (customer service, warranty, spare parts, adjacent goods)  Strong sales or delivery (speed, credit, convenience, etc)  Strength in customer perceptions (brand, status, prestige, large installed base)

12. 12 Which type to choose? Choose cost strategy when…  Economies of scale are critical (but perhaps unexploited)  Demand by customers is relatively homogenous  Few opportunities to enhance product and increase WTP  Customers are price sensitive  Cost is a potential source of competitive advantage Choose a differentiation strategy when…  Customers are very heterogeneous in their product demands Half like Coke, half like Pepsi….  Some customer segments willing to pay a premium for quality  Economies of scale or learning don’t exist or are already exploited by market leader, who focuses on “mid- range” segment  You have expertise in the area to be differentiated

13. 13 Generic risks to generic strategies Can you defend your low cost position?  Technological or preference changes can erase scale advantages Ford’s 1 st assembly line was down for years to install paint lines  Hard to be lean and mean forever  Often advantage lies in one stage in the value chain (more on this later) – is it vulnerable? Can you defend your highly differentiated position?  Brand is not always a sufficient BTE – imitators can get close  Preferences change, new brands can outflank old tired ones

14. 14 Agenda Cost/differentiation framework Core competencies framework Value-net framework Vertical integration framework

15. 15 What are core competencies? Core competencies lie at the heart of a firm’s source of competitive advantage  Some special ability to control costs or produce differentiated products Progressive’s IT system made it able to offer lower price and high service to profitable segment of the market Dell’s working capital and supply chain management  Supposed to be a combination of hard to imitate processes and knowledge

16. 16 Sales Mark eting Identifying core competencies Value chains are a good place to start Then benchmark cost and capabilities against competitors  If you are the “best” in a segment of the value chain you probably have a core competency in that activity The deeper/more specific you can be when identifying/defining core competencies the better Manu facturing Develop- ment Research

17. 17 Core competencies often take advantage of competitors’ weaknesses What is Dell’s core competency? Why did it work? Why couldn’t IBM/HP replicate it? What is Wal-Mart’s core competency? Why did it work? Why couldn’t Kmart replicate it?

18. 18 Core competencies in vertical integration decisions and corporate strategy Can be a very useful tool for thinking about the boundary of the firm  At the business unit level think about what activities in the value chain are best performed internally and which can be outsourced  At the corporate level think about which business units are central to the firm and which can be spun off Note the close relationship between synergies and core competencies in this set-up

19. 19 Core competencies as a model Very intuitive mental model of a firm  Create profit by focusing on what you are good at Not always clear what is a core competency and/or how the concept differs from sources of competitive advantage Can be tautological (we’re good at what we’re good at) Not a dynamic model  Sony was supposed to have a core competency in miniaturization but they missed the iPod market

20. 20 Agenda Cost/differentiation framework Core competencies framework Value-net framework Vertical integration framework

21. Customers Company Suppliers ComplementorsCompetitors The value net The value net holds that the amount of value a company can capture is both defined and constrained by other players in the “net”

22. 22 Key questions asked in “Value Net” analysis What are the sources of value in a firm’s interactions? How can a firm increase total value created in the web? How can a firm increase its share of total value created?  Increasing total value in the web doesn’t mean you will necessarily capture it! Lucent, Xerox, IBM……

23. 23 Vertical axis is “traditional” Total economic surplus = customer willingness to pay minus your suppliers’ costs of production minus the costs you add Your share of the surplus is your total price charged to customers minus what your suppliers charged you minus your other costs  Very complementary with “cost” vs. “differentiation” strategies

24. 24 Complementor vs. Competitor axis looks at your ability to sustain value capture A player is a complementor if customers value your product more when they have the other player’s product than when they have your product alone.  Oscar Mayer and Coleman’s mustard A player is a competitor if customers value your product less when they have the other player’s product than when they have your product alone.  Pepsi and Coke

25. 25 Who are the complementors? CarsAuto loans, insurance, roads Televisions VCRs, satellite TV showsTV guide Fax machines Phone lines CatalogsDelivery services HardwareSoftware GameCubeGame titles Complementors are critical to business success!

26. 26 However, complementors can steal value! Computer industry example  Microsoft and Intel are complementors of computer hardware companies, yet they constrain the value hardware players can capture  How is Dell a complementor rather than a computer manufacturer? Value net is also complementary to “core competencies” – you may figure out “non-central” activities allow most value capture These dynamics mean you may have uneasy relationships with complementors, even though they are necessary to increase total value of an industry

27. Changing the players can increase your value capture Bring in customers - Increase industry demand. This helps competitors, but may be worthwhile for you. To do this…  Educate consumers about your product (Diapers in Asia)  Pay customers (esp. early adopters) to play  Subsidize some customers, other full paying customers will follow (Initial discount to lower risk) Bring in suppliers  Compaq / AMD / Intel Bring in complementors  Do it yourself. Nintendo - both h/w & s/w. Intel  Pay complementors to play (at least initially) Bring in competitors – does this ever make sense?  Sometimes!

28. There are methods to increase your value-added Your value added = Size of the pie when you are in the game - Size of the pie when you are not in the game. How to increase added value? Limit your supply DeBeers and diamonds Downside: Shrinks the pie today; invites entry Lower competitors’ value Take over critical complementary functions Questions to ask: What is your added value? How can you increase value by changing supply, buyers, suppliers, complementors, or substitutors in your value net? What is the value added by other players? Should you be increasing or decreasing their added values?

29. 29 Agenda Cost/differentiation framework Core competencies framework Value-net framework Vertical integration frameworks

30. 30 Two major rationales for vertical integration Rationale 1: Increase market power  Ability to charge higher prices or price discriminate  Eliminate double marginalization  Foreclose competitors from suppliers or customers Rationale 2: Improve economic efficiency  Improve technical or productive efficiency Lower costs by joining parts of value chain  Improve transaction efficiency Reduce hold-up when suppliers have power Increase investments which may be risky due to hold-up  Improve incentives (“agency efficiency”) Reduce incentive conflicts or allow better monitoring

31. 31 However, vertical integration has costs Costs of vertically integrating  Can add layers of bureaucracy or management Outside core competencies, can we get it cheaper from the market? Are market incentives better in motivating managers?  E.g. McDonalds franchises to ensure quality Can raise intra-organization influence costs (lobbying, decisions that are inefficient but benefit one part of the firm)  Can turn previous suppliers or customers into competitors, increasing costs or decreasing market size

32. 32 Transaction cost economics focuses on relationship-specific investments A relationship-specific investment is one that isn’t very valuable for another trading partner except the one who benefits from it  Site specificity: you locate your plant right next to a customer’s factory  Technical specificity: you build expensive metal molding equipment for a specific car  Dedicated asset specificity: you undertake a major specific investment with a specific customer in mind, and a very thin market  Human capital specificity: you train all of your employees on the specialized equipment of a certain supplier

33. 33 Relationship-specific investments can cause market failure Sources of market failure with relationship- specific investments  Underinvestment due to risk aversion or uncertainty  Fear of hold-up or other opportunistic behavior Vertical integration can limit these problems  Align investment incentives  Remove incentives for hold-up or opportunism

34. 34 Horizontal integration is a different ballgame Why horizontally integrate?  Scale Market power, exploit economies of scale, increase power with suppliers  Gain access to new technologies  Gain access to new customer sets  Gain access to new geographies  Provide synergies between product lines Comcast/Disney, AOL/TW

35. 35 Next time Talk about your round 5 decision for the CSG (re-investment decision) Introduction to game theory, and applications to cases we’ve studied so far, the CSG, and new cases