The strategist’s mantra

CHAPTER2

8 MINUS C: POSITIONING

YOUR FIRM AGAINST

THE COMPETITION

CORE COMPETENCIES

Every manager knows the strategist’s mantra:

“To be successful, your firm must have a core competency.”

The concept of core competencies is pervasive. We conducted an online

search of business publications in 2003 and found more than 3,000 arti­

cles containing the term. (Another 3,000 mention “competencies,” ap­

parently taking for granted that they were “core.”) Many of these

articles identifY the core competencies that make specific firms success­

ful. South Mrican life insurance company Citadel’s core competency is

its advice. BlueCat Network’s core competency is “developing high

quality software.” Indeed, most managers can readily identifY the core

competencies of their own firms.

The term “core competencies” has exploded onto the strategy scene

in just a few years.Wben we searched for articles published in 1990, we

found only 10 that mention the term. W hile the term is new, the un­

derlying concept is not. Strategists have put new words to an old con­

cept and that old concept is as simple as it gets: To be successful, firms

have to do something well. If there is any nuance in the current incar­

nation of this concept, it is that firms should not do the things that they

do badly.

— — — ———— –? —

28 KELLOGG ON STRATEGY

Unfortunately, strategic thinking often fails to extend beyond mak­

ing a list of things done well. Managers often make such lists during the

dreaded SWOT analysis breakout session of a firm’s annual retreat (see

Chapter 1). Such an exercise has some value, if only to stimulate discus­

sion. But analysis of core competencies cannot be boiled down to a few

minutes of list making and an hour of discussion. It takes considerable

time to come up with a defensible, quantifiable list of core competen­

cies. Once the competencies have been identified, there are many addi­

tional issues to be reckoned with that are usually ignored.

The rest of this chapter provides an intellectual foundation for the

concept of”doing things well” and introduces a framework for analyz­

ing strategy that accomniodates specific concepts such as core compe­

tencies, as well as many other popular strategic concepts. We call this the

B-C (“B minus C”) framework. Because the B-C framework is both

powerful and general, we think it is an ideal tool for organizing strategic

analysis. As a way of motivating the B-C framework, we begin by dis­

cussing the sometimes shaky relationship between core competencies

and profits.

COMPETENCIES AND PROFITS

Core competencies do not guarantee profits, as many examples prove.

Throughout the 1990s, American Airlines ranked among industry lead­

ers in efficiency and customer satisfaction, and its Sabre subsidiary has

the best computerized reservation system in the industry. Even so, pro­

longed industry pricing woes nearly forced American to join many of

its competitors in seeking bankruptcy protection. For more than three

decades, pharmaceutical giant Merck has led the industry in research

and development expertise and output. But Merck has lost patent pro­

tection on most of its successful drugs and currently faces the same fate

for cholesterol blocker Zocor, the world’s second leading selling drug.

Many wonder if its pipeline of new drugs is strong enough for Merck

to maintain its elevated status. We could go on and on-competencies

do not guarantee profits.

OPe reason for the frequent disconnect between core competen-

8 MINUS C 29

cies and profits is that several firms may possess the same competen­

cies, leading to destructive competition. American is not the only

hub and spoke carrier. Merck is not the only pharmaceutical com­

pany researching cholesterol reduction. Even firms that seem to enjoy

a dominant market position can see their dominance erode over

time, as new firms enter the market. In video gaming, Atari begat

Nintendo, which begat the Sony Playstation and the Xbox. In desk­

top computing, Xerox was the real innovator, but was followed by

IBM, which then saw a stream oflow priced imitators: Leading Edge,

Compaq, Dell, and Gateway. Some incumbents seem to enjoy long

spells of dominance-think Alcoa Aluminum or Starbucks coffee­

but successful incumbents should always expect other firms to try to

grab some of the profits for themselves.

Even in the absence of competition and entry, firms with core com­

petencies often fail to prosper. Most major league baseball teams attract

millions of fans every year and receive nonstop media coverage. Yet

most teams lose money, while many of their employees (the players)

reap small fortunes. There are many other examples of firms that are

squeezed by their top employees (hospitals, law firms, and universities

among them) .The problem these firms face is that they have not tied up

the key assets that create their competence.

( Still other firms are squeezed by distributors or retailers. Just ask any firm that sells to Wal-Mart whether it is easy to turn a profit. Wal-Mart

accounts for nearly 10 percent of all nonauto related retail sales in the

United States, and Wal-Mart customers do not take much notice of

who makes the products that Wal-Mart sells. It is sufficient for the brand

to have some credibility, and for the price to be extremely low. This

gives Wal-Mart the upper hand when negotiating with competing ven­

dors, so much so that Wal-Mart’s “take no prisoners” negotiation style

with vendors is legendary. In fact, not only does Wal-Mart obtain deep

discounts from its suppliers, it forces them to invest in distribution tech­

niques that hold down Wal-Mart? costs.Just like baseball teams that do not

control their key asset (the athletes), consumer goods suppliers do not

control a key asset (the _ channels offered by Wal-Mart) . The result is the

same: Profits are hard to come by.

30 KELLOGG ON STRATEGY

These examples show that for a firm to be profitable, it is not enough

to possess a competency (i.e., do something well). The following must

also be true:

” The firm must avoid the ravages of competition.

• The firm must survive the threat of entry.

• The firm must control the assets that determine the value of its

competence.

These are not the only limitations of the competency concept. There

are a host of issues associated with putting the concept of competencies

into practice. How does a firm identifY a competency? How does it ac­

quire it? How does it know that the competency is genuine?

Fortunately, we can deepen our understanding by turning to a basic

concept in microeconomics: the concept of value creation. In our view,

this simple economic idea can serve as the foundation for all of strategy.

In the remainder of this chapter, we lay out the key economic principles

of value creation. In Chapter 3, we present the resource-based view of the firm, a powerful theory that clarifies how value is converted into profits.

VALUE CREATION: THE KEY

TO PROFITABILITY

We begin our economic analysis by defining value:

Value is the difference betv.reen the benefits enjoyed by a firm’s cus­ tomers and its cost of production.

There are other ways to define value, and we do not claim that ours is

the only reasonable definition. However, this particular definition leads

to many insights, and that is why we like it. Perhaps the most important

of these insights is expressed by the following proposition relating posi­

tioning to value creation:

A :j]_rm in a competitive market can earn a profit only if it creates more

value than its rivals.

8 MINUS C 31

To understand why this is true, it is helpful to discuss a few preliminar­

ies regarding the concepts of costs and benefits.

A firm’s costs include all expenses associated with production, includ­

ing the cost of capital1 A good cost accountant can help a firm compute

its costs. Benefits can be thought of as the value (measured in monetary

terms) that the customer derives from consuming the firm’s output.

When measuring benefits, it is important to deduct any offsetting incon­

veniences. Sometimes, benefits and inconveniences are easily measured

in dollars. A good example is the fuel savings enjoyed by consumers who

purchase Toyota’s Prius hybrid car, or the hundreds of dollars in increased

fuel costs for those who purchase a Hummer H2 sports utility vehicle.

More often than not, benefits and inconveniences are intangible. The

Prius offers owners the piece of mind that comes with a car that re­

ceives top marks for reliability. But Prius owners must also accept mod­

est performance and limited luxury appointments. The H2 offers

unique style and superior off-road performance, but it is not the most

comfortable car for everyday driving. Consumers balance all of these

factors and more when assessing the benefits of different vehicle

choices. W hen it comes to most intangible benefits, different customers

would place a different monetary value on each.

It is sufficient that consumers perceive that a product offers superior

benefits, even if there is no tangible evidence of those benefits. This may

explain why many participants in blind taste tests cannot tell any differ­

ence between Coke and R C Cola, yet most consumers prefer to have

Coke on hand rather than RC. Coke’s market dominance is evidence

enough that it delivers more value than RC. It is futile to argue that con­

sumers are somehow irrational; this conclusion is more likely a failure of

the analyst to truly understand the basis for the consumer’s choice. We

will take for granted that consumers do, in fact, make the right choice, and that this reflects the underlying product benefits. We revisit this argu­

ment in Chapter 4, when we detail how to quantifY benefits.

B Minus C

We are now ready to understand our proposition. It helps to introduce a

bit of notation. Let B measure the benefits or happiness the product

32 KELLOGG ON STRATEGY

gives its customers (measured in monetary terms). B should also ac­

count for any user costs, which include, for example, the costs of acquir­

ing the product, learning to use the product, storing the product, and

disposing of the product. Once we account for user costs) we can think

of B as the maximum amount that consumers would be willing to pay to

purchase the product. Let C measure production costs. This includes the

cost of all inputs that had to be sacrificed or used up in the production

process of that good (also measured in monetary terms). This is the

amount that cost accountants are supposed to report as the cost of

goods sold.

The amount of value that a firm creates is equal to B-C (B minus

C). To prove our proposition, we need one more variable. Let P stand

for the price. We can now divide value, or B-C, into two components:

1. B-P = the benefits enjoyed by consumers, above and beyond the purchase price. Firms that offer the highest levels of B–P will en­ joy the largest market shares.

2. P-C = the seller’s profit per unit sold. Firms that offer the highest P-C will have the biggest unit profit margins.

It should now be obvious that if a firm offers higher B–C than its ri­

vals, then it can set price so that it simultaneously (1) offers consumers

more B–P than do competitors, and (2) enjoys a higher P-C than competitors. This translates into a larger market share, profit margins,

and higher profits.

One important implication is that from the standpoint of a firm’s

strategy, there is no such thing as a price position or a price advantage. Any firm

can set a low price, but if it does not have low costs, it will simply go

out of business faster than its rivals. By the same token, any firm can set

a high price, but without high benefits, it will have no customers and

soon perish. Successful positioning requires creating B-C. Pricing is just

the means used to translate that position into profits.

Firms that create high B-C do not have to aim for both a higher

market share and higher margins at the same time. It might make more

sense_-for a firm with a B-C advantage to increase its price to the point

where it enjoys very high margins but a relatively small market share

8 MINUS C 33

(think Neiman Marcus). There are other situations when it makes sense

to keep prices low, resulting in a dominant share but with lower margins

(thinkWal-Mart).We detail the choice between a “margin strategy” and

a “share strategy” later in this chapter.

CONNECTING GENERIC STRATEGIES

AND 8-C

In the books Competitive Strategy (1 980) and Competitive Advantage

(1985), Harvard Business School’s Michael Porter argues that firms

should choose among three generic positions or strategies (“cost advan­

tage,” “differentiation advantage,” and “niche strategy”)2 These generic

strategies are often a cornerstone of strategic analysis. W hile the B-C

framework is an alternative to generic strategies, you need not unlearn

the generic strategy approach. In Table 2.1, we see how the two ap­

proaches compare.

Cost advantage is analogous to reducing C across a broad product

line, while maintaining reasonable B parity. Firms such as Hyundai and

Saturn succeed in this way. Firms such as Kia have lower costs, but their

B is so low that they have failed to win many customers.

Differentiation advantage stems from desirable characteristics that

make a firm unique, such as Federal Express’s reliability or Nordstrom’s

customer service. A differentiated firm is uniquely better on dimensions

Porter’s Generic Strategy

Cost Advantage

Differentiation Advantage

Niche Strategy

Table 2.1 Porter’s Generic Strategy Framework

B-C Analogue

Lower· C; Comparable B

Higher B; Comparable C

Higher B-C in narrow

market space

Examples

Dell Computer; Wal-Mart

Cray, Inc. (Supercomputers);

Nordstrom

Gateway (home office

market); Bed Bath &

Beyond

34 KELLOGG ON STRATEGY

that virtually all consumers prefer (as opposed to being better in ways

that appeal to just a few consumers). This is analogous to increasing B in

the eyes of most consumers.

A focus strategy is a cost or differentiation strategy that is limited to a

submarket and may not appeal to most consumers. For example, the

Martin-Brower Company is a global distribution services company that

is the largest provider of supply chain management services to the Mc­

Donald’s worldwide restaurant chain. These services include specialized

distribution and extensive truck fleet operations. Because the firm is fo­

cused on a narrow customer base (mainly one customer!) the firm is

able to generate higher benefits and/ or is able to produce its services at

lower costs relative to a firm configured to serve a greater variety of

customers.

Focus strategies are especially attractive when competitors are pursu­

ing broader cost or differentiation strategies that fail to deliver consis­

tent B-C across all customer segments. Microsoft Word dominates the

word processor software market, but does not deliver particularly high

value to a number of customer segments. For example, many academic

researchers need to type complex mathematical formulae, a task that is

well beyond the capabilities of MS Word. This has created an opportu­

nity for TCI Software Research, whose Scientific Word dominates this

small but profitable market niche.

In addition to being a complementary means to express the firm’s

position, we think many analysts will find the B-C framework more

flexible than the generic strategy approach. The B-C framework builds

on the generic strategies by allowing us to think quantitatively about

positioning. Positioning is more than just a trichotomous choice; firms

are precisely positioned along a B-C spectrrun. Viewing positioning

along a continuum will aid in successful identification and implementa­

tion of strategy. This point is nicely illustrated by considering what hap­

pens to firms that are “stuck in the middle.”

Stuck in the Middle

Many. strategists, including Porter, admonish firms not to pursue more

than one generic strategy at a time, lest they end up stuck in the middle,

8 MINUS C 35

with neither a cost nor a differentiation advantage. There are many ex­

amples of firms that unsuccessfully straddle strategic options, making a

compelling case for avoiding such apparent strategic indecision. How­

ever, by considering this argument in light of the B-C approach, we see

that there is much more to the concept of ” stuck in the middle” than a

simple strategic rule of thumb.

The B-C framework does not imply a necessary tradeoff between

strategic options. Consider the value creation strategies listed in Table

2.2. Firms can decrease C, increase B, or do both. The latter value cre­ ation strategy should be possible according to the B-C framework.

In fact, there are many examples of firms that appear to offer higher

B and lower C than does the competition-lean-differentiators, if you

will. Toyota and Honda revolutionized the market for small and mid­

size family cars in the 1980s by offering better quality at lower prices.

American Airlines seemed to occupy such a strategic position through

the 1980s, before Southwest expanded and American’s unions extracted

large wage concessions. In these examples, firms improved their produc­

tion technology (Toyota and Honda through total quality management,

American through its revolutionary Sabre reservation system) and, as a

result, enjoyed higher B and lower C.

There are many other examples of firms that succeed without offer­

ing either the highest B or lowest C, but simply by offering high B-C:

Dannon yogurts, Panasonic DVD players, Dell computers, and Chr ysler

Table 2.2 Stuck in the Middle Strategy

Value Creation Strategy

Achieve lowest cost position in industry.

Achieve highest benefit position in industry.

Decrease C and increase B to achieve highest value position in industry.

B-C Position

Outcompete rival.

Outcompete rival.

Outcompete rival.

Porter Position

Cost advantage.

Benefit advantage.

Stuck in the middle.

-?–· ? – – ??-·– ?????—_,.___–???— —

36 KELLOGG ON STRATEGY

minivans are all market leaders that give consumers high value, but offer

neither the highest B nor the lowest C. The facts clearly show that firms

can succeed without having the highest B or the lowest C. Moreover, it

would be foolish to advise Dell to abolish its customer service (reduce

B by a lot, just to save a bit on C) or to tell Chry sler to build more

powerful minivans that handle like sports cars (raise C a lot and B a lit­

tle). These firms have found just the right balance of B and C; any

movement would reduce their value creation.

Yet we do not wish to dismiss the potential problems of being stuck

in the middle. If consumers have sufficiently differentiated preferences,

then the firms that pursue value creation may end up offering high

value to the small number of median consumers, leaving the bulk of the

market to firms that focus on the high or low end.

We also suspect that firms get stuck in the middle because of prob­

lems with strategic implementation. W hen firms face the following

conditions, clarity of strategic purpose may be valuable:

• Achieving cost or benefit excellence involves discontinuities. It is

sometimes difficult to improve product quality without substantial

investments. For example, it costs $500 million to develop a new heart drug; one cannot develop a heart drug that is half as good for

$250 million. In these situations, compromise leads to disaster? vast sums spent with no benefit improvements to show for it. Dis­

continuities also characterize the world of entertainment, where

one movie (or one recording) might be slightly better than the

rest, yet command the lion’s share of sales revenues.

• This problem is magnified if lower level managers have great discre­

tion over resources. Managers who confiont daily the tradeoffi that

determine the success of corporate strategy may need unambiguous

guidance from senior executives, or find it difficult to determine how

to resolve them. If different managers commit to different objectives,

and the firm cannot achieve any objectives through piecemeal mea­

sures, then success may again be elusive. We recommend that senior

executives make the firm’s objectives clear to all managers. It never

hurts to create value, but if the firm seeks a specific position in the marketplace, be sure everyone knows where the firm is heading.

B MINUS C 37

The bottom line is that “stuck in the middle” may have more to do

with strategy implementation than with strategy selection. Firms that

create the most value should outperform their rivals. But firms may pre­

fer the simplicity of focusing on B or C to the complexity of weighing

B against C, especially when there are discontinuities.

Disruptive Technologies

Another popular concept in strategy, disruptive technologies, fits nicely

into the B-C framework. The term, which was coined by Harvard

Business School’s Clay Christensen, is used to describe new products

that offer consumers low quality but are also much cheaper to produce

than existing technologies. These products have the potential to funda­

mentally change the landscape of an industry. Honda’s early motorcycle

line (smaller engines than Harley’s), personal computers (less powerful

than mainfiames), and e-mail (less personal than “snail mail”) are among

countless examples.

Using the Porter framework of benefit and cost advantage, it is easy

to understand the threat posed by disruptive technologies. Firms with a

benefit advantage iguore the new technology. In short order, the benefit

leaders suffer irreparable harm as their market shares wither. This seems

like a deep insight, combining an old theory (Porter’s) with a novel idea

(Christensen’s) to reach new and profound conclusions.

The B-C framework reveals that there is actually nothing new or

profound in the concept of disruptive technologies. In fact, it is just an­

other example of the general concept that firms thrive by creating

value. Remember that consumers do not care only about B; they care

about B-P. W ith its dramatically lower C and somewhat lower B, a dis­

ruptive technology enables new firms to offer attractive B-P positions

to even the most demanding customers, while still enjoying higher

profit margins. The predictable result is that the firms with the highest

B-C come to dominate the market.

Christensen observes that many disruptive technologies are “stealth

technologies,” in the sense that they often go unnoticed when first in­

troduced, but catch on as the technology catches up. In effect, B im­

proves over time, increasing the B-C differential in favor of the

38 KELLOGG ON STRATEGY

newcomer. But the observation that new technologies improve over

time is true in general, not just for low B/lower C disruptive tech­

nologies. (As we discuss in Chapter 8, the learning curve is nearly

ubiquitous.)

In the final analysis, the concept of disruptive technology is just a

special application of B-C. Firms that are wedded to the pursuit of a

benefit advantage-mistakenly believing that a high B is sufficient for

success-will be surprised by a disruptive technology. But firms that pay

attention to B-C will not.

THE TARGET

All firms have a natural or target customer segment. In B-C talk, the

target segment is the particular set of customers for whom the fir m

generates the highest B-C. Either the tar get segment perceives the B

of the fir m’s output to be high relative to the perception of other cus­

tomer s, or the target segment is less costly for the fir m to serve relative

to the cost of serving other customers. A target segment can be large

(think of the customers attracted by Wal-Mart’s low prices or Toyota’s

reliability) or small (only a select group of audiophiles would consider

paying $1 0,000 for a Theta Digital home theater sound processor.)

Using Porter’s terminology, targeting is relevant to firms pursuing a

niche strategy.

It is usually easy to see how a product generates B-C for its target

segment. Breyer’s Carb Smart line of ice creams generates B for cus­

tomers who struggle to reconcile their love of ice cream with their de­

sire to stay on the Atkins diet. Pre cor’s folding treadmills target exercise

fanatics with limited floor space. Apex Digital’s low end DVD players

target customers with small screen televisions who would not notice

the improved quality of higher cost units.

Target identification is essential for positioning. Without it, firms will

usually fail to provide an attractive level of B-C for any customer seg­

ment. If the firm’s management sincerely believes that everyone should

prefer the firm’s product or even view it as equivalent to the offerings of

competitors, it is likely (and unfortunate for the owners of the firm)

that the firm’s management has never explicitly performed target iden-

————-

B MINUS C 39

tification. In identifying their target, firms should not only isolate cus­

tomers who perceive a higher B when consuming the firm’s output, but

also determine the cost differential of serving different customers. For

example, managers of firms whose products are expensive to transport

should know exactly how costs change with distance. Quite simply,

thinking strategically about one’s business means identifying the firm’s

target customer segment and truly committing to this definition.

Ted Williams became a baseball hitting legend as a player for the

Boston Red Sox. Williams is famous for saying, “Get a good pitch to

hit.” Williams’s hitting strategy is depicted in Figure 2 . 1 . He divided his

strike zone into 77 baseballs, 7 wide by 1 1 high. Williams projected what he would hit at each pitch location, from .230 on the low-outside

strike to .400 in what he called his “happy zone,” the heart of the plate,

belt high3 Another of Williams’s quotes, “All I want out of life is when I walk down the street people say ‘There goes the greatest hitter that

ever lived’ ” was realized in 1941, when Williams hit .406, making him

the last baseball player to break the magic .400 barrier.

SWINGING ONLY AT YOUR TARGET

Anyone who aspires to be known as the “greatest manager who ever

lived” would do well to take two lessons from Williams’s approach to

targeting:

1. Find the customer base that falls in your “happy zone”-the customers

to whom you can deliver the most value’ Williams knew that he

could not reach all pitches with equal effectiveness, so he studied

statistics on his own performance to assess where he had the most

success.

2. Be disciplined. Williams’s thorough knowledge of the strike zone

and willingness to lay off pitches out of his happy zone produced

a nearly 3-to-1 ratio of walks to strikeouts, an unheard-of statistic

for a power hitter. He farmed 64 times as a rookie, and never more

than 54 in any other season. Similarly, it requires a tremendous

amount of impulse control to resist “swinging” at customers who

are on the “low outside.”

40 KELLOGG ON STRATEGY

Figure 2.1 Ted Williams’s Happy Zone

Strike Zone

Ted’s “happy zone” high .300’s and .400s

.

These will get you in the .200s

Ted Williams thought of the strike zone as a grid of 77 balls. He learned that choosing where to s-..ving in the grid determined the hitter’s batting average. Low and on the out­ side was- least desirable, vvith the “happy zone” in the m iddle of the grid. Analogously, you can divide your customers into a grid, where your “batting average” is your profitability in serving a customer or customer segment. Ted would say, stick to your happy zone.

B MINUS C 41

Most business managers understand that there are customers they

should not serve. Yet those who have rigorously applied discipline to

customer targeting are strictly in the minority. Few firms have the

stomach to relinquish existing customers and identifY customers whom

they will not serve. But successful B-C analysis requires managers to as­ sess value creation by customer segment, and stick to those segments for

which the firm delivers superior B-C.

TARGETING SUPPLIERS

Most targeting efforts look at ways to increase B for specific customer

segments. It is also possible to create value by targeting suppliers. Target­

ing suppliers creates value by reducing the costs of critical inputs­

those inputs that have a large impact on unit costs.

To understand how to target suppliers, consider that the input sup­

pliers to any one firm usually have outside options. Disney’s animators

have their choice of movie studios, Lucas Verit y can sell its antilock

brake components to its choice of car makers, and Boise Cascade can

sell its wood to countless furniture makers. The amount that a firm has

to pay an input supplier is almost entirely determined by the attractive­

ness of the supplier’s outside options. Supplier targeting means identifY­

ing inputs whose outside options a