Uniqueness does not lead to differentiation unless it is valuable to the buyer. A successful differentiator finds ways of creating value for buyers that yield a price premium in excess of the extra cost. The starting point for understanding what is valuable to the buyer is the buyer’s value chain. Buyers have value chains consisting of the activities they perform just as a firm does, as discussed in Chapter 2. A firm’s product or service is a purchased input to its buyer’s value chain. Steel is a raw material that is typically cut, bent, machined, or otherwise converted in its buyer’s production process to become part of components and ultimately end products, for example. The buyer’s value chain determines the way in which a firm’s product is actually used as well as the firm’s other effects on the buyer’s activities. These determine the buyer’s needs and are the underpinnings of buyer value and differentiation.
Although buyer value chains are easiest to visualize for industrial, commercial, or institutional buyers, individual consumers also have value chains. A consumer’s value chain represents the sequence of activities performed by a household and its various members in which the product or service fits. To understand how a product fits into a household value chain it is usually necessary to identify those activities in which a product is directly or indirectly involved, typically not all the activities a household performs. A television serves as entertainment for various members of a household during some periods of the day, and serves as a background noise during others. The set is typically switched on and off a number of times each day and the channel may be changed frequently. Traveler’s checks are typically bought in quantity at a bank and then used occasionally in the course of a vacation or business trip. Redeeming any extra checks after the trip involves a visit to the bank, which means that many checks are saved for future trips instead. A commercial, institutional, or industrial buyer’s value chain reflects its strategy and approach to implementation, while a household’s value chain reflects its members’ habits and needs. What is valuable for either type of buyer, however, grows out of how a product and the firm supplying it affect the buyer’s chain.
1. Buyer Value
A firm creates value for a buyer that justifies a premium price (or preference at an equal price) through two mechanisms:
- by lowering buyer cost
- by raising buyer performance
For industrial, commercial, and institutional buyers, differentiation requires that a firm be uniquely able to create competitive advantage for its buyer in ways besides selling to them at a lower price. If a firm is able to lower its buyer’s cost or enhance its buyer’s performance, the buyer will be willing to pay a premium price. If the components supplied by a well respected bicycle parts supplier allow a bicycle assembler to improve differentiation and thereby charge a higher price, for example, the assembler will be willing to pay a premium for the components. Similarly, the fact that Kodak’s Ektaprint copier lowers the cost of a finished set of collated documents with a recirculating document feeder and an in-line automatic stapler that reduces the buyer’s personnel cost means that the buyer is willing to pay a premium for the copier. In both instances, the firm was able to enhance the competitive advantage of its buyer even though not selling its product at a cheaper price.
The principle is the same for households and individual consumers, though the measurement of buyer cost and particularly buyer performance may be more subtle. For household buyers, the cost of a product includes not only financial costs but also time or convenience costs. The cost of time for a consumer reflects the opportunity cost of using it elsewhere, as well as the implicit cost of frustration, annoyance, or exertion. Buyer value results from lowering any of these costs for the buyer. A refrigerator that uses less electricity than other refrigerators can command a premium. A vacuum cleaner that saves vacuuming time and reduces exertion is also valuable to the household buyer. Offering direct marketing that saves the buyer shopping time may not be valuable if the buyer enjoys shopping, however.
Raising buyer performance for consumers involves raising their level of satisfaction or meeting their needs. If a TV set’s better picture quality and faster warmup time lead to more satisfaction in watching it relative to competitors’ sets, for example, the buyer will be willing to pay a premium. Status or prestige are important needs just as are the features of a product or its quality. Although it may be difficult to value buyer performance for consumers, their value chains will suggest the important dimensions of satisfaction.
Industrial, commercial, and institutional buyers sometimes resemble consumers in instances where their objectives are not solely profits or revenue growth. Buyers may value a supplier that provides satisfaction or prestige for executives or other employees even if it does not contribute to the profit of the company. This reflects the differences that often exist between employee and company goals. Similarly, a hospital values a diagnostic device that yields better treatment even if the hospital does not earn higher profit as a result. This reflects both the goal of providing quality patient care and the fact that a large number of hospitals are nonprofit institutions. Many organizations have other goals in addition to profitability even if they are profit making, which may enter into buyer value.
2. The Value Chain and Buyer Value
A firm lowers buyer cost or raises buyer performance through the impact of its value chain on the buyer’s value chain. A firm may affect the buyer’s chain by simply providing an input to one buyer activity. Frequently, however, a firm’s product will have both direct and indirect impacts on the buyer’s chain that go beyond the activity in which the product is actually used. For example, weight is important in a typewriter that is moved from place to place though it is not relevant if one views the buyer activity simply as typing. Moreover, a firm typically impacts the buyer not only through its product but also through such activities as the logistical system, order entry system, sales force, and applications engineering group. Even firm activities representing a small fraction of total cost can have a substantial impact on differentiation. Sometimes the buyer has individual contact with value activities of the firm (e.g., the sales force) while in other cases the buyer only observes the outcome of a group of activities (e.g., the ultimate on-time or late delivery). Thus, the value a firm creates for its buyer is determined by the whole array of links between the firm’s value chain and its buyer’s value chain, represented schematically in Figure 4-2.
Heavy trucks offer a useful example of multiple links. A heavy truck directly influences its buyer’s logistical costs—a function of the truck’s carrying capacity, ease of loading and unloading, fuel costs, and maintenance costs. The truck will also have indirect effects on its buyer’s other costs. Its capacity will influence the frequency with which the buyer makes deliveries. The truck may contribute product quality through the amount of shaking it subjects the cargo to, as well as the temperature and humidity conditions in transit. The truck may also affect the buyer’s packaging costs, a function of the protection required to avoid damage. Finally, the truck may incrementally affect brand identity through its appearance and the visibility of the logo painted on the side.
Not only will the truck itself affect the buyer’s value chain, but several other value activities of the truck manufacturer will probably affect the buyer as well. Spare parts availability will affect the downtime experienced by the buyer. Credit policies will affect the financing cost of the truck. The quality of the truck manufacturer’s sales force may well determine their helpfulness in suggesting new maintenance procedures and truck utilization practices. All these links between a truck manufacturer’s value activities and the buyer may potentially add to or subtract from buyer cost or performance. The principle also holds true for household buyers.
The links between a firm and its buyer’s value chain that are relevant to buyer value depend on how the firm’s product is actually used by the buyer, not necessarily how it was intended to be used. Even the most carefully designed product can yield unsatisfactory performance if a buyer does not understand how to install, operate, or maintain it or if it is used for a purpose for which it was not intended. For example, a housewife may get terrible results from a frozen food product if it is cooked at the wrong temperature. Similarly, a machine can malfunction quickly if it is not oiled in the right place.
Every impact of a firm on its buyer’s value chain, including every link between firm and buyer value activities, represents a possible opportunity for differentiation. The more direct and indirect impacts a product has on its buyer’s value chain, the richer the possibilities for differentiation tend to be and the greater the overall level of achievable differentiation. A truck manufacturer with a sophisticated understanding of how it impacts its buyer’s value chain, for example, can not only design the truck to provide greater benefits to the buyer, but can perform other value activities such as service, spare parts supply, and financing to be more valuable to the buyer.
Differentiation, then, grows out of all the links between a firm and its buyer in which the firm is unique. The value of being unique in a value activity is its direct and indirect impact on the buyer’s cost or performance. A firm’s overall level of differentiation is the cumulative value to the buyer of the uniqueness throughout its value chain. This cumulative value can be calculated and provides the upper limit of the price premium the firm can command relative to its competitors. Since the firm must necessarily share some of the value it creates with its buyer in order to give the buyer an incentive to purchase, the actual price premium will be somewhat less in practice.
3. Lowering Buyer Cost
Anything a firm can do that lowers the buyer’s total cost of using a product or other buyer costs represents a potential basis for differentiation. Actions that lower the cost of buyer value activities representing a significant fraction of the buyer’s cost constitute the most significant opportunities. There are frequently many ways to lower buyer cost if a firm has a sophisticated understanding of how buyers use its product and how its various marketing, delivery, and other activities affect buyer costs.
A firm can lower its buyer’s cost in a number of ways:37
- Lower delivery, installation, or financing cost
- Lower the required rate of usage of the product
- Lower the direct cost of using the product, such as labor, fuel, maintenance, required space
- Lower the indirect cost of using the product, or the impact of the product on other value activities. For example, a light component may reduce the transport costs of the end product
- Lower the buyer cost in other value activities unconnected with the physical product
- Lower the risk of product failure and thus the buyer’s expected cost of failure.
Table 4-1 lists some of the ways in which a firm’s product itself can lower the buyer’s direct cost of use. In addition to lowering buyer cost through its product characteristics as illustrated by the examples in Table 4-1, a firm can lower its buyer’s cost of use through many other value activities. Reliability of deliveries reduces buyer inventory, and short lead times in supplying spare parts reduce downtime. Ordering and billing procedures can reduce the buyer’s accounting and procurement costs. American Hospital Supply’s on-line ordering system for hospitals, for example, allows purchase orders to be placed by less skilled, lower paid clerks instead of purchasing agents. A firm can also provide buyers with advice or technical assistance that reduces their costs. Intel, for example, has a development system to help buyers design its microprocessors cheaply and rapidly into their products. A firm can also take over buyer functions, in effect forward integrating into the buyer’s value chain. In wholesaling, for example, Napco stocks shelves, prices goods, and replaces slow-moving items for its buyers.
A number of more extended examples will illustrate how firms have lowered their buyers’ costs and achieved differentiation. Kodak’s copiers, described earlier, lower the buyer’s cost of making collated and stapled copies. The industry leader Xerox was more concerned with copying speed itself, which failed to recognize the buyer’s full cost of using copiers. In the moving industry, Bekins has offered guaranteed pickup and delivery dates, a fixed price for a move that is quoted in advance, a $100 late payment to the buyer if the move does not occur on time, and reimbursement for damaged goods based on their replacement costs instead of purchase price. All these lower the buyer’s direct and indirect cost of a move (and increase peace of mind as well). In fasteners, Velcro uses a system involving many small plastic hooks that connect to a fibrous pad. Velcro fasteners are easier to install than other forms of fastening devices and eliminate the need for skilled labor in the fastening steps on the buyer’s assembly line.
In seeking opportunities to lower buyer costs, a firm must chart in detail how its product moves through or affects the buyer’s value chain, including the buyer’s inventory, handling, technology development, and administrative activities. It must also be familiar with all other products or inputs its product is used with, and understand how its product interfaces with them. The firm must also identify every other value activity in its value chain that affects the buyer’s chain.
4. Raising Buyer Performance
Raising buyer performance will depend on understanding what is desirable performance from the buyer’s viewpoint. Raising the performance of industrial, commercial, and institutional buyer depends on what creates differentiation with their buyers. Thus the needs of the buyer’s buyer must be understood, requiring the same analysis as the analysis of buyer value. A truck sold to a buyer who is a consumer goods company that uses it to carry goods to retail stores provides an example. If the retail stores desire frequent deliveries, the consumer goods company will be very interested in a truck with carrying capacity to make frequent deliveries at reasonable cost. Similarly, in selling to automobile manufacturers Velcro achieves differentiation because its fasteners are more flexible and allow interior design options for cars that are appreciated by consumers.
Raising performance of industrial, commercial, or institutional buyers can also be based on helping them meet their noneconomic goals such as status, image, or prestige. In heavy trucks, for example, PACCAR has achieved a high level of differentiation for its Kenworth “K- Whopper” trucks by careful handcrafting and by tailoring them to individual owner specifications. These have little to do with the economic performance of the truck. However, many Kenworth buyers are owner-operators who derive value from the appearance and brand image of their trucks.
For products sold to consumers, raising buyer performance will be a function of better satisfying needs. American Express traveler’s checks are used in a stream of consumer activities in which cash needs are irregular, travel plans change, banks are not always available, and a risk of theft or loss exists. American Express differentiates itself because its buyers value the security of redemption anywhere as well as rapid replacement of lost checks. American Express provides easy redemption anywhere via many offices throughout the world that operate long hours.
5. Buyer Perception of Value
Whatever the value a firm provides its buyers, buyers often have a difficult time assessing it in advance. Even careful inspection and test driving of a truck, for example, does not allow the buyer to assess completely its comfort, durability, fuel usage, and repair frequency. A detailed understanding of how the physical product affects a buyer’s cost or performance often requires extensive experience in its use. A buyer faces an even more difficult challenge in knowing how all the other activities a firm performs will affect buyer value. Moreover, a buyer cannot always completely or accurately gauge the performance of a firm and its product even after the product has been purchased and used.
Buyers, then, frequently do not fully understand all the ways in which a supplier actually or potentially might lower their costs or improve performance—that is, buyers often do not know what they should be looking for in a supplier. While buyers are more likely to understand the direct impacts of a firm on their value chains, they often fail to recognize the indirect impacts or the ways in which other supplier activities besides the product affect them. Buyers can sometimes perceive too much value just as they can fail to perceive enough. For example, buyers sometimes see only the price of a product when measuring its value and do not add up other, more hidden, costs such as freight or installation. The buyer’s perception of a firm and its product, therefore, can be as important as the reality of what the firm offers in determining the effective level of differentiation achieved. Moreover, buyers’ incomplete knowledge of what is valuable to them can become an opportunity for differentiation strategy, since a firm may be able to adopt a new form of differentiation preemptively and educate buyers to value it.
A buyer’s incomplete knowledge implies that the differentiation actually achieved may well be based in part on the factors used by the buyer to infer or judge whether a firm will lower its cost or improve its performance relative to competitors (or is doing so currently). Buyers use such indications as advertising, reputation, packaging, the professionalism, appearance, and personality of supplier employees, the attractiveness of facilities, and information provided in sales presentations to infer the value a firm will or does create. I term such factors that buyers use to infer the value a firm creates signals of value.
Some signals of value require ongoing expenditure by a firm (e.g., packaging, advertising) while others reflect the stock of goodwill or reputation a firm has built up over time. Similarly, some signals of value are not directly controlled by the firm at all (e.g., word of mouth). Signaling may be as necessary, in some industries, to expose hidden costs of a product on which the firm has an advantage over competitors as it is to expose unrecognized benefits. In some, if not many, industries, signals of value are as important as the actual value created in determining realized differentiation. This is particularly true where a firm’s impact on buyer cost or performance is subjective, indirect, or hard to quantify, when many buyers are first-time buyers, buyers are unso- phisticated, or repurchase is infrequent. Good examples would be legal services, cosmetics, and consulting. However, the need to signal value is present in virtually every industry.
Buyers will not pay for value that they do not perceive, no matter how real it may be. Thus, the price premium a firm commands will reflect both the value actually delivered to its buyer and the extent to which the buyer perceives this value. This is illustrated schematically in Figure 4-3. A firm that delivers only modest value but signals it more effectively may actually command a higher price than a firm that delivers higher value but signals it poorly.
In the long run, the upper limit of the price premium a firm can command reflects its actual impact on buyer value—impact on buyer cost and performance relative to competitors. Through effective signaling of value, a firm may be able to command a price in excess of true value for a time. Eventually, however, the failure of a firm to deliver perceived value to match its price tends to become known, partly through the efforts of competitors.38 The converse is less true, however. By failing to signal its value effectively, a firm may never realize the price premium its actual value deserves.
Figure 4-3. Actual Versus Perceived Buyer Value
6. Buyer Value and the Real Buyer
A firm or household does not purchase a product; individual decision makers do. Both actual value and signals of value are assessed and interpreted by these decision makers. The identity of the specific person or persons who make the purchase decision will influence, if not determine, the value attached to a product. The decision maker may not necessarily be the person who pays for the product (e.g., the doctor, not the patient, chooses drugs) and may be different from the user (e.g., the purchasing agent chooses a product used in the plant). The channel may also make its own decision about whether to stock a firm’s product and whether the firm is a desirable supplier.
Different decision makers will value different things about a supplier and use different signals to assess them. A purchasing agent may not value reliability as highly as a plant manager, for example, because the purchasing agent is more detached from the consequences of product failure. The purchasing agent may be motivated more to keep the cost of purchase to a minimum. There may also be more than one decision maker for a product. Both husband and wife typically decide on buying a house, for example, and travel agents and tour brokers all can play a role in choosing an airline or resort hotel. Similarly, the purchasing department and plant engineer often jointly choose pieces of production equipment. A number of individuals frequently influence the decision maker though they may not participate in the decision directly. Such individuals may be able to veto a supplier, despite the fact that they do not have the power to choose.
Identifying the value a firm creates for the buyer and the signals of value used by the buyer, then, rests on determining the identity of the real buyer. The process of identifying the real buyer often suggests new dimensions of performance that are not immediately apparent if the buyer is viewed as the firm or household. These can include such factors as prestige, personal relationships with supplier personnel that are valued in their own right, and the desire to avoid personal risk in the purchase decision by choosing a well-known supplier. IBM has exploited its position as a “safe” choice as a supplier, for example, as has Kodak in amateur photography. The expertise and sources of information available to the real buyer will also shape what signals of value will be convincing—an engineer might use technical publications and advertising in technical journals as signals while an accounting clerk might be more swayed by polished salespeople and glossy brochures.
Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.