Traditional views of cost-quality advantages

Cost and quality are the staples of competitive positioning. As discussed, Porter identified three generic strategies based on cost and quality advan­tages: overall cost leadership, differentiation, and focus strategies.1 The cost-leadership strategy involves offering a mass-marketed, low-priced, low-quality product. The differentiation strategy involves offering a pre­mium-priced, high-quality good, and the focus strategy targets a premium- priced product for a smaller niche audience with a special definition of what is high quality. While there has been much discussion of strategic positioning using cost and quality, this chapter offers an overview of the process of the evolution of this competition.

The traditional, static understanding of the relationship between cost and quality and competitive advantage is based on accounting approaches, such as those popularized by the DuPont model. According to this model, the company’s return on equity (ROE) is a function of its margins, sales volume, and the financial policy of the firm. As shown in the equation below, ROE is related to (1) profits/sales (also called operating margins or return on sales, often labeled ROS), (2) volume (high sales volume given the firm’s asset investment), and (3) assets/equity (which is equal to 1 + debt/equity, a major part of the financial policy of the firm). Thus:

ROE = profits/equity = ROS x sales/assets x (1 + D/E)
or (margins) x (volume) x (financial policy)

Porter’s low-cost strategy achieves profits through a high-volume, low- margin approach, while his other two strategies are low-volume, high- margin approaches to generating profitability. Under this view of compet­itive advantage, firms compete for the high-volume market primarily

through cost improvement, and they compete for lower-volume markets primarily through quality improvements. For all three strategies profits are produced by improving margins and/or volume.

1. Useful Insights from the Cost-Quality View of Competitive Advantage

This view of competitive advantage has proven highly useful. Kenichi Ohmae provides an example of the kind of strategic analysis that can be done using this view. In his set of “profit diagrams” in The Art of Strategic Thinking,2 he demonstrates a systematic way to look for margin- and volume-improving strategies based on cost and quality. A machine-tool company had asked him how it could improve the profitability of the prod­ucts in its line. Ohmae developed a diagram to address the question of how the profitability of a certain product can be increased. The diagram out­lines a series of decisions managers must make in deciding how to increase profits. For example, the first choice in raising profits is to lower product costs, increase pricing, or increase volume. If managers decide to raise prices, they can do so by raising the market price or reducing margins for distributors. Sales volume can be increased by boosting market share, ex­panding the market segment, or moving into new segments. Each decision thus leads to a new set of choices, and ultimately to a set of actions to boost quality or decrease cost.

In addition, Ohmae recommends assessing whether each component of a product needs to be changed, analyzed, or left alone, depending upon whether it is more or less costly and of lower or higher quality than the component used by the firm’s best and fiercest competitor. Product costs and quality can be improved by changing design, reducing fixed costs, or cutting variable costs, through value analysis (VA) and value engineering (VE). Value analysis and engineering are methods of reverse-engineering the product from the perspective of both the customer and manufacturing costs. Each component of a firm’s product is identified and redesigned or eliminated to reduce cost ( via value engineering) or increase quality ( via value analysis) to the customer. Value engineering and analysis are used whenever the components of a firm’s product are inferior or too costly compared to the components of the best products in the marketplace. In sum, according to this view, advantage is created by the components con­tained in the product and the price and attributes of the product as a whole. Advantage is said to exist when the product offers the correct com­bination of price and quality. Product positioning at a given point in time matters.

2. Critique of Traditional View

While this analysis captures the fundamental relationship between cost and quality, it is reactive rather than proactive. The model considers com­petitors only to the extent that they shape market conditions and the cur­rent benchmark levels of price and quality. This view does not look at potential competitive responses and future actions in the market. Ohmae himself cautions that competitor positions should be considered. “No product is sold in the desert or on the moon; manufacturers’ prices and the various competitive segments they serve are determined in a competitive environment,” he warns. “What if all manufacturers in the market are pro­ducing similar high-quality products and offering them to the market at a relatively low price (i.e., with narrow profit margins)? In this case, it would be disastrous for the company to modify Product A’s design in order to reduce costs … because the seemingly lower quality product would be driven out of the market by the low-priced, high-quality products already competing for the customer’s favor.”3 But even here he is concerned pri­marily with current competitor positions rather than future actions. This analysis sees the market at one point in time rather than examining how it evolves over long periods of time. There is no dynamic aspect to the profit improvement and product component analyses suggested by Ohmae and discussed earlier.

While Porter examines some movement within industries, even he does not consider how cost-quality positioning evolves. He presents an exten­sive discussion of competitor analysis and tools for analyzing the future evolution of the industry, including product life cycles and changing buyer behaviors. But competition on cost and quality are viewed from the more static position of the generic strategies. As he notes, one of the primary risks of the generic strategies is for “the value of the strategic advantage provided by the strategy to erode with industry evolution.”4

3. The Dynamic View

It is our contention that the risk posed by evolution that Porter mentions has become so great that it can no longer be considered as an afterthought to strategic thinking. Competition is so intense and markets are so dy-namic and volatile that this evolution has become the dominant force in strategic action. Companies can no longer count on succeeding by choos­ing a generic strategy. The most important aspect of competition is, not current position, but the changes created by the dynamic interaction be­tween rival firms. Thus the position of the firm offers only a temporary advantage. It is the firm’s ability to manage a series of interactions success­fully that determines the success of the company.

Over long periods of time, companies are forced to shift their cost ( and price) and quality positions. Industries readjust their minimum acceptable level of quality and maximum acceptable price required to be a player in the marketplace. There are revolutions in quality that raise standards and then new revolutions that shatter those standards. There are innovations in product or process technology that drive dramatic improvements in quality or reductions in cost. These cycles of change are growing progres­sively shorter. Advances in information, manufacturing, and basic tech­nology have accelerated so quickly that many processes and products now have lives of three months or less before they become obsolete.

Source: D’aveni Richard A. (1994), Hypercompetition, Free Press.

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