Here we explore how Competitive Advantages operate, in order for marketing to later combine with business strategy in starting and prolonging such an advantage (detailed in “Marketing and Competitive Advantages”).
What is a Competitive Advantage (CA)?
A Competitive Advantage (CA) is an ability to deliver higher product utility ‘quality’ to the customer at a lower cost to the company, superior to that of rivals and they are unable to imitate the advantage:
This widening of the utility-cost gap is achieved by securing Competitive Advantage sources (CA sources) that either increase product utility per unit sold or reduce cost for the company to produce each unit:
The result of CA sources is a ‘product utility to customer – cost to company’ gap which is wider and therefore superior to that of rival products.
Marketing builds upon this underlying CA’s raw economic utility-cost gap advantage over rivals, by casting the company’s CA into customer-relevant products. This further raises customer perceived utility and lowers customer’s perceived total cost to purchase and use it.
Pricing can then be set between customer utility and cost to the company, in order to create marginally superior customer value over rivals and yet still be above threshold profitability to grow shareholder value:
From the diagram we can determine how wide the ‘utility to customer- cost to the company’ gap is for a product line, by simply adding:
A. customer value (e.g. reported customer satisfaction, % market share growth rate, customer value benchmarked over rivals),
B. financial performance (e.g. unit % profit margin, Return on Invested Capital etc.).
Example CA source:
Recruitment of a specialist staff in a technical area (a CA source) leads to a technically improved subsequent product for customers (raised customer utility). Customers are willing to pay a higher price for this utility, higher than the additional raised company cost per unit to recruit the specialist staff, because customers are unable to buy the same improved product from rivals. The result is a widening of the ‘utility-cost’ gap and a price that offers both superior customer value and grows shareholder value.
6 CA types and their CA sources.
Studies on thousands of successful companies listed on the stock market have shown there to be 6 types of CA, each with tens of different CA sources:
Each CA type describes how their cluster of numerous CA sources deliver superior customer utility at less cost over rivals.
Scale economies– If an asset that delivers value to the product is a fixed cost- a cost that remains fixed regardless of the volume of units sold through it- then the greater the volume of units sold that use the asset, the lower the per unit cost of each individual product sold.
Any part of a company which is a fixed cost asset that delivers value to the customer can be a source of scale economy CA.
Examples of CA sources:
- Advertising: fixed cost advertising spread over many existing and potential customers leads to better perceived utility to result in more sales volume and a decline in cost to advertise each unit sold.
- Research & Design: as the fixed cost of research and innovation is spread over greater volume, the R&D cost per product unit sold is lowered.
- Manufacturing: the fixed cost of production equipment spread over increasing units sold leads to a lower cost for each unit manufactured.
Scope Economies– By increasing the range of product lines that can share and so better utilise the same indivisible overhead costs and fixed cost assets, the result is a lowering of the total cost of producing each product line and therefore lowering per unit sold cost too.
Whereas a single company with only one product line would suffer higher per unit cost as the indivisible costs and assets are less well utilised but instead stand idle during slack periods.
Examples of CA sources:
- Selling: sales staff travel time cost is distributed across a greater revenue base of products.
- Advertising: e.g. multiple product sharing the same indivisible catalogue cost or an umbrella brand’s fixed cost divided across multiple sub-brands.
- Purchasing: bulk purchasing of raw materials and components commonly shared across multiple products to realise lower unit cost (bargaining the exploitation of supplier’s fixed cost need to supply, in turn lowering your own variable cost of inputs).
Learning curve/ core competency-
For every doubling of the volume of items sold or of tasks completed in delivering customer value, the costs decrease or quality of task delivery improves by a fixed proportion (up to a given period).
Examples of CA sources:
- Learning from a sufficiently large client base to rise above rivals up the learning curve in the delivery of a complex product or knowledge service or process.
- Job specialisation advantage as staff can become more focussed in tighter niches of specialism, improving their ability to perform the task.
- Incorporating customisable technology (i.e. uniquely proprietary to yourselves as opposed to easily purchasable, generic technology of no CA) into a unique business process to create an ambiguous barriered, cost lowering/ utility raising CA source. (e.g. Tetrapac developing and owning the machines that produced their packaging, Rolls Royce’s sophisticated engine fan blade manufacturing capability).
Network effect– The more subscribers to a product or service there are, the greater the value that the service offers to each individual user. This is due to enabling sharing information, connecting with more users or sharing fixed costs amongst more users.
Examples: telephone network, social networking sites, eBay, shared private jet ownership, internet search engines, different manufacturer’s car showrooms clustered together, Silicon Valley.
As the network expands, further benefits to each user also include: more follow-on products launched, standards set, repair costs go down, easier to sell second-hand.
‘Toll’ distribution access– Securing a restricted access to downstream demand of customers, like a ‘toll’ bridge. Or securing a restricted access to an upstream supply of raw material. Or charging companies or end users for using a distribution channel owned by yourself.
Examples of CA sources:
- Upstream exclusive access to a core contributor to downstream customer value. E.g. ownership of a gravel pit for selling construction rock to customers within a 10 mile radius of the pit.
- Downstream exclusive access to customers via a distribution channel that delivers customer value. E.g. Starbucks positioned on a main shopping street.
- Ownership of and charging for (toll bridge) a distribution channel. E.g. supermarkets bargaining higher profit margins from suppliers in return for their shelf space.
Switching cost– If your existing customer was to try a rival product offering, the following represent a cost that the customer would experience if they were to switch, making it not worth their while in trying alternatives.
Examples of CA sources:
- Learning cost- the cost of having to learn a new system leading to lost productivity.
- Loyalty programmes- loss of loyalty rewards.
- Buyer’s habit brand- the cost of switching due to psychological uncertainty in trying a rival brand.
Also as a mixture of the above:
- Focus economies- CA sources arising from focussing on a niche target market.
- Strategic alliance with a CA’d partner- locking up access to their unique CA away from rivals.
- New-to-industry business model with rival’s immobility to copy- learning curve taken from a previous business along with scope and scale economies (e.g. Ikea, Dell, Zara, Southwest Airlines).
- Outsourced supplier- a comparative advantage and specialisation leading to a mixture of CAs: switching cost, scale economies, scope economies and learning curve.
Competitive Advantages create customer value.
Grouped under the 6 CA types, all the CA sources either raise a company’s customer value or lower rival’s customer value in a variety of ways:
Marketers are then able to caste the CA sources’ basic economic utility-cost advantage into tailored products that better meet and exceed customer needs beyond those of rivals.
Customer value that rivals cannot match.
The reason why CA sources are so powerful in delivering superior customer value over rivals is because rivals cannot imitate them. Rivals cannot duplicate the customer value that CA sources generate because of two features:
1. CA sources first become available to the sales market leader in a customer need market segment (or to alert challengers).
To be able to secure a CA source in serving a customer need market segment, it requires a company to be the first to reach a threshold level of unit volume sales market share, in order to spread the cost of acquiring the CA source across many units sold.
For an explanation of this key dynamic to Competitive Advantages, click here.
With sales volume needing to be sufficiently high enough to economically justify the CA source’s initial cost outlay, only the sales volume market leader in a customer need segment (or alert challengers) can feasibly secure a CA source.
2. Once secured, the CA sources enable a company to quickly outdistance rivals’ customer value.
All CA sources have a simple reinforcing loop that works as follows. Investing in securing the CA source serves to increase customer utility or lower company cost per unit beyond that of rivals. The result is an improvement in customer value over rivals and therefore an increase in sales:
This sales and profit growth enables reinvestment back into further developing the existing CA source (e.g. buying a second production machine) or gaining new CA sources (e.g. securing exclusive distribution through a new channel) to further improve customer value over rivals. So the cycle is repeated again.
The subsequent growing gap in sales volume and market share over rivals means that they are increasingly barriered from being able to match your customer value offered (since their falling sales into the same fixed cost base raises their per unit cost and a lack of reinvestment into matching the customer utility).
The reason why the 6 CA types have been attributed to company successes in the stock market is because the reinforcing loop nature generates sufficient success as to be identified by investors.
The reinforcing loop nature of the CA types is shown below, where customer utility increases or cost to the company declines at a decreasing rate (along the side axis) as more sales volume is sold (along the bottom axis):
Toll distribution CA type also features this reinforcing loop but via an indirect means: securing more distribution enables greater sales volume into the earlier reinforcing CA types of learning, scale, scope and network effect.
Switching cost CA also features a slight reinforcing loop, again via indirect means: the longer retention of repeat purchasing customers serves to grow sales volume (or at least sustain volume) into prior reinforcing CA types of learning, scale, scope or network effect.
CA source criteria.
Summarising the above, a CA source is any asset, process or market position secured that:
1. Increases ‘quality’ utility to the customer and can command a price premium above its cost. Or lowers cost to the company to deliver customer utility.
2. Has a positive feedback reinforcing loop in further raising utility or lowering cost as more sales volume pass through it, and
3. Cannot be imitated by direct rivals serving that customer need segment.
These assets, processes or market positions generally fall within the 6 CA types listed above.
Developing a Competitive Advantage.
To develop a CA, the aim is to widen ‘customer utility-cost to the company’ gap each year in serving the market need segment, beyond the utility-cost gap of rivals:
Widening the utility-cost gap involves aligning multiple CA sources in order to produce a greater incremental utility gain and cost reduction compared to rivals for every 1,000 sales (or 10 sales or 100,000):
As this utility-cost advantage is incorporated by the company into delivering products of marginally superior customer value over rivals, sales will increase. This leads to reaching the next 1000 sales sooner than rivals, compressing subsequent utility-cost improvements inside a shorter time period, to widen the utility-cost gap over rivals further still:
The gap is the CA, resulting in a sustained marginally superior customer value to that need segment over rivals, with profit margins and sales growing in turn.
This dynamic is reflected in Michael Porter’s insight that CA’d companies are either customer utility differentiated or cost leaders (and focussed). Management become increasingly skilled at implementing CA sources that either raise utility (differentiated) or lower costs (cost leader), until it becomes a culture. And the consumer brands the company accordingly.
The result of the above is that a competitively advantaged company would have a cluster of CA sources that increase customer value per customer and to more customers. Until a point where the company dominates that customer need segment of the overall market:
Strengths differ from CA sources.
Ideally, the CA should eventually lead to dominating the share of the market and therefore the company reaches natural market boundary limit buffers, including limits to growth from Porter’s 5 forces: buyer and supplier power, degree of rivalry, new entrants and substitutes.
With a slowing in sales growth, the CA’s reinforcing loop halts. However in dominating the market share, rivals cannot gain minimum efficient scale of sales volume necessary to compete on equal customer value terms.
But the company’s expansion may hit internal rather than external growth limits, such as bureaucracy, diseconomies of scale, cost of complexity and other bottlenecks. These internal factors inhibit a CA from increasing customer utility or lowering costs and therefore sales growth ends well before the company has dominated the market.
In this situation, CA sources now become a mere relative strength.
Most strengths were previously a past CA source, with their reinforcing loop nature causing the company to notably excel in a certain dimension of customer value over rivals, before it could be copied away by rivals. Examples of strengths:
Sales force knowledge.
However unlike CA sources, strengths no longer have a reinforcing loop and so do not scale up well: increasing sales volume throughput into the strength often weakens customer value output rather than improves it. For example, customer service often worsens with increasing customer volume. Sales growth caused by guarantees can later lead to costly claim submissions. The circle of influence of powerful contacts diminishes as a % of growing sales.
With strengths lacking a reinforcing loop, they can more easily be duplicated by rivals with smaller volume in that market segment.
If a strength is considered to generate enough customer value to be worthy of duplicating to gain customers, then rivals will make the necessary investment to match that strength. This results in dragging their customer value up to parity with yours. As a consequence, rivals nullify your strength and your Return on Invested Capital (RoIC) spread eventually reverts back down to earning the same as your Cost of Capital (CoC).
Therefore the above CAs and relative strengths can be linked to RoIC % spread:
Business Strategy as matching “where you compete” with “how you compete.”
In essence, business strategy seeks a customer need segment of the market as the “where we compete” that would both 1. value an existing strength of the company, and 2. offer CA sources to the volume leader or alert challenger serving that customer need segment.
The result of targeting such a segment could enable the company to deliver market segment-leading customer value as its “how we compete.”
(The other components to business strategy are the ‘soft’ human aspects: a mission and objectives to motivate, metrics to monitor progress, systems and function-level strategies to vitally implement.
So a successful strategy is a matching of “how we compete” with “where we compete” (the analytical ‘hard’ components), and then crucially implementing this with the essential human soft components).
The above coverage on CAs and strategy can be connected to Shareholder value growth:
“Strategy is a deliberate search for a plan of action that will develop a business’s competitive advantage and compound it.”
Bruce Henderson- founder of Boston Consulting Group strategy consultancy.
Therefore strategy seeks to grow shareholder value by:
• Developing a competitively advantaged market position (RoIC % spread),
• Sustain the competitive advantage for as many years as possible (longevity), and
• Achieving the most sales within markets that extend the competitive advantage (growing sales in order to enable investing as much capital that can be accommodated into earning that RoIC % spread).
In figuring how to do this, the challenge is to reach the right balance between:
… And maintaining this balance for the longest period of years possible.