Define value creation and the components that can be used to determine value creation per unit. How is value creation related to competitive advantage?
The value for a product or service is the inherent utility that customers gain from a product. Although utility for a customer is subjective and has a different definition for each customer, it can be broadly considered as the happiness that a customer gets by owning or using the product. Alternatively, utility can be objectively defined in terms of the product attributes like: performance, design, longevity, quality, after sales service, etc. If these attributes are monetized and summed up to a total of U units, U would represent the average utility value per unit of a product to a customer. The value that company creates is the difference between the utility that customers get from the product(U) and the costs of production (denoted as C).
Hence, value creation per unit = U- C
The higher the value created by the company to the customer, the more is the flexibility that a company can enjoy with respect to its pricing options. Normally, the selling prices of the products are usually lower than that of the utility generated. This is called as consumer surplus. In a non-monopolistic market where prices are determined by the other companies in the same industry, the customer is privileged to reap the benefits of lower prices. Although it is not possible to determine the unique assessment of utility for each customer, the prices are generally marked lesser than the utility generated by the product. The promise of a higher utility to the customers can allow the company to mark up prices in accordance with the other competitors in the industry. Alternatively, it can lower prices to fuel the demand for its product in the market to increase overall sales volume. This leads to competitive advantage.
2. What is a value chain? Why is efficiency so important in an organizations value chain?
The value chain is the chain of activities that a company performs that transforms the raw inputs to the final product from which the customers derive value. The process of transformation takes into consideration all the cost functions of the company. These functions play their part in differentiating the product and lowering the overall cost structure for the final product.
When these functions perform their takes efficiently, the company can realize a significant reduction of production costs, internal transaction costs, turnaround times and product quality. This reduces the overall cost structure. When efficiency is pegged up to the state of the art techniques, more utility can be created. Both factors maximize the difference between U and C which allows for higher competitiveness and profitability for the company. It is to be noted that high efficiency is an attribute that all the primary and the support functions can strive to achieve for. It is not just restricted to logistics and production but can also be extended to human processes, R&D, Information Technology.
3. What building blocks can an organization use to sustain competitive advantage?
Four distinct factors contribute towards the competitive advantage of the company over its competitors: efficiency, quality, innovation and customer responsiveness. The combination of these four generic principles can lead to higher product differentiation and lower cost structure; both of which create higher utility values for the customers. It is to be noted that these factors are not independent of each other but quite often enhance the others along with them.
Efficiency: Broadly, efficiency can be defined as the overall quantity of inputs that is required to produce a given output. As discussed previously, all the functions of the company should strive towards achieving superior efficiency and thereby reducing the overall cost structure for the final product.
Quality: A product is perceived to be of superior quality when its attributes are rated higher than those of its competitors. The measure of quality can be defined as a product of two factors: Quality when used as a measure of excellence, quality when used as a measure of reliability. Excellence may refer to product design, features, functions, styling, customer service, etc. Reliability is the level of consistency achieved by the product when it repeatedly performs the tasks that is designed for. Hence, it improves the utility derived by a customer in the long run. In recent times, there is an ever-increasing emphasis being laid on reliability. It is one of the fundamental principles of TQM(Total quality management) and is considered as an absolute imperative for a company’s survival.
Innovation: There are two main types of innovation; product innovation and process innovation. Innovative products have superior attributes when compared to the existing products. Process innovation refers to the ways in which products are produced and delivered to the customers. It is often accompanied by reduction of overall costs to the company. Although innovation is not a strategy to boost short term profits, it is always required to sustain the company in the long run.
Customer Responsiveness: Since it is always not possible to predict the utility derived by the customers for any product in the market, it becomes necessary to maintain a proper feedback mechanism that determining the level of differentiation that a product has over the other products in the market. Improving quality of the existing features or incorporating new features that are lacking in the existing product based on customer feedback are integral aspects of customer responsiveness. Customer responsiveness also incorporates the unique features that are improved in response to the unique needs of different customers. Another important aspect of customer responsiveness is the total time taken from the point where the customer raises a request for a product or service till the point where it is delivered by the company to the customer. Slow customer response time is a major source of customer dissatisfaction. Some of the other aspects of superior customer responsiveness are improved design, service and after sales support.
4. What does an internal analysis help a company to determine? How does this contribute to the overall health (value creation, competitive advantage, profitability) of the company?
Internal analysis helps managers to assess the financial metrics of the company to understand whether the strategies that the company adopts contribute to profitability or not. It helps to determine:
– Their profitability standing versus the other competitors in the market
– The present profitability when compared to the historical profitability figures
– Whether the strategies that are being adopted maximize the value that is being created
– Whether the cost structure is optimized in a way that is better off when compared to that of its competitors
– If the resources of the company are being used to their fullest effect
Some of the key financial metrics that help assess the health of a company are:
– ROIC: Net profit/Invested Capital
– COGS: Cost of Goods Sold (production costs)
– SG: Sales, General and Administrative Expenses
– R: Research and Development Expenses
– Working Capital
– Property, Plant and Equipment
– Return on Sales
– Capital Turnover
– Net Profit
– Invested Capital
These components, when used together determine the strategic functioning of the company and the distinctive advantages that the company builds over a long span of time. Different strategic investments have their unique time periods in which they start contributing positively to the overall ROIC. Hence, efficient internal analysis of the company and its closest competitors is a useful technique to understand the areas where the company is developing and sustaining a competitive advantage. It plugs the loopholes faced when deploying a strategy into practice. When a strategy is formulated and put into practice, Internal analysis provides empirical results associated with the implementation of the prescribed strategy. This feedback can be used again iteratively for further strategy formulation. Hence efficient internal analysis reduces the total loop time of strategy formation, execution and feedback. This analysis when used to analyze other competitors, can give insights regarding their unique strengths and weaknesses which further helps in ideating and prescribing strategy.
In summary, efficiency and reduction in cost structure is a direct result of Internal analysis. Corrective actions with respect to strategy formulation determine the areas where the highest value can be generated for the customers. Creation of high value products and services in an efficient manner allows for pricing flexibility for the company. This improves the overall competitiveness and profitability of the company.
Why do companies fail? How does competitive advantage relate to failure?
Companies fail because of a multitude of reasons:
– Drastic decline of the company’s competitive advantage
– Lower profitability than that of their competitors for a sustained period
– A loss in the ability to generate and attract resources
– Decline in the profit margins and invested capital
The above factors are culminated results of three paradigms that undermine a company’s profitability and competitive advantage:
Inertia: The inability of a company to adapt according to the changing dynamics of the market. Sometimes the very fundamental reasons because of which the company gains competitive advantage might become the causes of inertia in the organization. The once favored processes by which decisions are formulated and made become too bureaucratic and resistant to change. Fleet footed organizations, without placing too much power and authority in a bureaucratic system steer clear from the problems caused by turf battles. It is this nimbleness that makes the companies malleable to the changing needs of the environment.
Prior Strategic Commitments: Without adapting readily to the changing needs of the customers, companies might often escalate their existing strategic commitments because of significant sunk costs that have already been incurred to execute the prescribed strategies. If the companies cannot success to avoid this pitfall, the problem gets worse and the company only specializes in the execution of the previously prescribed strategies.
The Icarus Paradox: When companies successfully formulate and execute a certain strategy, there is a tendency to repeat the same strategy which resulted in success. The same strategy might lead to some more success in the near future but sooner or later the companies might get too myopic and fail to understand the new and changing market conditions. The way in which the Greek figure Icarus lost his wings by flying too close to the sun, companies might face a situation in which the very strength of the company that drove its competitive advantage might become a bane to itself.
In order to avoid failure, companies must focus on all the four blocks of competitive advantage at all times. Inertia, Prior strategic commitments and the Icarus paradox might drive the company to specialize in one aspect of competitive advantage without focusing on the other aspects. Very quickly the increased emphasis on one aspect, say engineering quality can come at the cost of reduced responsiveness to customers. This undermines the competitive advantage of the company and leads to failure.
1. What are functional level strategies? How can functional level strategy contribute to efficiency?
Functional level strategies are organizational plans with respect to functional areas like human resources management, operations, research and development, marketing, etc. They are customized according to the specific nature of individual businesses and used to complement other higher-level business and strategic choices.
Functional level strategies that are aimed at improving the effectiveness of the company’s processes can contribute to the development of competencies that differentiate the products in the market based on quality, increase the scope for innovation or reduce the overall cost structures of the company. In the textbook, we have seen the example of United Technologies where the improvement of process efficiency (by implementing a program called ACE) led to another desirable consequence for its chain of products: reliability. This improvement in process efficiency for one product line led to similar improvements in the product offering and reliability of the other products in the company’s portfolio. Some of the functional level strategies that are used to improve efficiency are:
– leveraging economies of scale and learning economics to reduce costs per unit
– Adopting flexible manufacturing technologies to allow for the depth and variety of product attributes
– Reducing customer defection rates to greatly enhance customer retention
– Implementing Just in Time systems for overall operational efficiency
– Emphasis on R to develop products that not only create superior value but are easy to manufacture as well
– Increased investments in training and upgrading the skillsets of employees to curb attrition rates
– Introducing self-managed teams to create a leaner organizational structure
– Cultivating a strong leadership that percolates strong commitments towards efficiency
– Innovative pay structures according to respective roles that keep the employees intrinsically motivated towards achieving the company’s strategic objectives
– Reducing transfer costs and transaction costs between the different functions of the organization in the pursuit of creating a level turf that improves efficiency
2. Describe economies of scale and its relation to competitive advantage. What strategic significance does economies of scale have?
Economies of scale refers to the phenomenon when overall unit costs are reduced when intermittent costs like R&D costs, Marketing costs, transactional and informational costs are reduced when there is a significantly large production volume. The large production volume reduces the overall marginal costs by distributing them over a large volume. The costs incurred during the manufacturing of multiple copies of the same product are significantly lesser than those incurred during the earlier phases. Also, a company that is characterized by large production volumes can reap the benefits of greater labor division and specialization. According to Adam Smith, this practice of management in turn improves process efficiency and controls the rate of innovation that is to be maintained. By making extensive improvements to production capacity, unit costs fall and ROIC is enhanced. It is important to note that there is a threshold value for each company where the benefits of economies of scale cap out. Beyond which, it might incur diseconomies of scale where larger production volumes are associated with higher unit costs. This is due to managerial inefficiencies as there might be additional layers of hierarchy associated with larger production volumes. Information transfer might not happen seamlessly and might even get distorted as it gets transferred from one layer to another. Even though large production volumes might reduce some of the functional costs associated with each unit but may give rise to other costs such as transactional costs, bureaucratic costs or the costs associated with the loss/distortion of information.
Hence it is essential to reap the benefits of economies of scale by targeting a production volume that leverages reduced overall unit costs but keeping the volume in check so that it does not lead to diseconomies of scale.
3. How does innovation relate to competitive advantage? What can be done to sustain innovation?
Competitive advantage is a direct consequence of superior innovation. Innovation can refer the R&D efforts in improving the product attributes that better satisfy the customer’s requirements, or improvement in the managerial/operational practices that streamline the production chain giving rise to a lower cost structure. Both factors together increase the difference between Utility and Cost, leading to higher profitability. Quite often than not, successful innovations are imitated and bridges the competitive gap between companies. Because of this effect, companies must ensure a sustained commitment towards process and product innovations.
It is to be noted that not all innovation attempts result in a product that is commercially viable. Hardly 10-20% of the R products result in commercialized end products for the customers. There are several factors that can contribute towards successful innovation and sustaining innovation in the long run.
– Accurately gauging the demand for the innovative product to justify the costs associated with developing the product
– Appropriate commercialization of the technology that underlines the justified advantages that a customer might have
– Positioning of the new product (price, distribution, promotion, advertising) in such a way that maximizes the initial adoption rate of the product
– Reduce the total cycle times associated with product invention, development and launching it in the market
Also, tight cross functional integration reduces the high failure rates associated with product innovation. Some methods to improve this relationship between different functional structures are:
– Establish cross functional teams to develop products. These teams may comprise of individuals from the R, marketing and production teams spearheaded by a leader who is adept at integrating perspectives from different paradigms
– Individuals in these teams have a sense of authority and responsibility for team results and are dedicated to the project for its entire duration
– Physical colocation that brings in a heightened sense of association, thereby facilitating communication
– Proactiveness on the part of the managers about building upon the knowledge gained from past successes and failures
4. How does customer relations contribute to competitive advantage? What is the effect of customer relations on value creation and its components?
Maintaining cordial customer relations introduces the aspect of brand loyalty. By consistently meeting the customer’s needs and tweaking the product attributes accordingly, the customers tend to keep buying products associated with the same brand rather than that of its competitors. When all other factors that contribute to utility are same, the company with a higher base of loyal customers can enjoy the benefit of increased pricing options. A listening mechanism that focusses on customer inputs may also fuel innovation when there is a lack of intuitive ideas from the company’s end. Responsiveness to customer’s needs is often accompanied with insights that improve the other blocks of building competitive advantage. An unbiased sample base of customer feedback gives the company insights regarding the specific pillar of competitive advantage that must be focused more than the others. In addition to internal analysis, customer responsiveness is another technique with which managers can identify the areas where processes can be improved. Also, it is no be noted that customer responsiveness is not an end in itself: the company needs to stay on the forefront of innovation and explore various ways in which the customer needs can be better satisfied.
After ensuring superior efficiency, quality and innovation, value can also be created in terms of the level of customization that is offered and an overall reduction in the response time after customer’s needs have been identified. Customer responsiveness is achieved through leadership that emphasizes the importance of customers and bridges the gap between customers and the company. Enabling employees to think in terms of the customer offers internal feedback regarding product or process improvements at every stage of the product’s life cycle. Therefore; enhancing product attributes, streamlining processes that improve efficiency and reliability, customer loyalty, customization and minimal response times create the most value for the customer’s money and sustains the level of attraction that they have towards the company and its products.
References: Strategic Management: An Integrated Approach. 2017, 12th edition. South-Western Cengage Learning. Charles W. L. Hill and Gareth R. Jones