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5 Product Differentiation INTRODUCTION This class session is fun because students can recognize the logic behind the positioning of many well-known products. Students are usually eager to participate in the discussion by sharing experiences that typify product differentiation. Students begin to demonstrate confidence, and maybe even satisfaction, in applying what they have learned in the course. We suggest that you use a more applied approach in this session because students have had a great deal of experience with product differentiation as consumers. Chapter 5 will help put much of their experience as consumers into a logical framework, especially with regard to bases of differentiation and the imitability of a base of differentiation. To quite an extent, this class session is a matter of helping students understand phenomena they have experienced repeatedly as consumers. Implementation issues surrounding product differentiation may require more formal explanation. The discussion about whether firms can simultaneously pursue both cost leadership and product differentiation can be both challenging and engaging. Students are usually quick to recognize that some firms appear to have a focus on both cost leadership and product differentiation. The goal with this class discussion should be twofold: provide students with a framework for examining the competitive advantage implications of product differentiation, and encouraging students to think more deeply about the business level strategies of cost leadership and product differentiation. Slide 5-2 Use this slide to show students that you are still in the strategic decisions part of the strategic management process and that you are still focusing on business level strategy. Slide 5-3 Use this slide to show students that you will be discussing the business level strategy of product differentiation. Give a very brief recap of the cost leadership strategy.  Teaching Points • Remind students that this discussion of product differentiation is a continuation of the strategic choices known as business level strategy. • Offer students a brief outline of the topics you will be discussing during this session: • Bases of Product Differentiation • Value of Product Differentiation • Product Differentiation & Competitive Advantage • Implementing a Product Differentiation Strategy • Pursuing Product Differentiation and Cost Leadership Strategies • Summary of Product Differentiation Discussion & Activity: A Favorite Local Restaurant Ask a student to identify a favorite local eatery. Ask the student why that name came to mind. What is it about that establishment that makes it memorable? You can expect answers like great food, great atmosphere, great location, great value (you get a lot for your money), etc. Now ask other students if they agree with the first student as to why that eatery stands out in the minds of people. Often there will be disagreement, especially if the first student says ‘great food’. Explain that the fact that this particular eatery came to mind is evidence of product differentiation. Depending on the level of agreement you can explain that the power of the differentiation is different to different people. Some may be willing to pay a premium price to eat there, while others in the class may prefer not to eat there at any price. Make the point that at least some people see something different and enticing about that particular eatery. Such perceived differences cause these people to prefer that eatery over others. If the differentiation identified for the local restaurant is based on something intangible like atmosphere or tradition, point out that differentiation is often in the minds of consumers. If the differentiation identified for the restaurant is tangible, ask students for an example of a product or service for which the base of differentiation is intangible. Things like famous brand names, logos, trademarks, and reputation will usually be mentioned. Point out that there may well be very little true difference between the famous brand and other products, but if consumers perceive a difference they will still have a preference for that product. Emphasize that perceived differences can be every bit as powerful as actual differences in the minds of consumers. Here are several questions you can ask students to get them to think about the issues you will be covering. • What has the restaurant had to do to create its differentiation from competing restaurants? • How easy would it be for other restaurants to imitate the differentiation that sets this restaurant apart from competitors? • Why has this local eatery endured when local restaurants have such a dismal history of failure? • Do employees of the restaurant do things differently from what is done in other restaurants to help reinforce the differentiation? • Could this restaurant ever become a national chain? Define Product Differentiation Product Differentiation Product differentiation is a business level strategy in which firms attempt to create and exploit differences between their products and those offered by competitors. These differences may lead to competitive advantage if customers perceive the difference and have a preference for the difference. Of course, such differences will lead to competitive advantage only if the differences meet the VRIO criteria.  Important Point: The critical element of a product differentiation strategy is that customers perceive a difference. There may or may not be an actual difference in the product itself. If the firm can convince the customer that there is a difference, even if there is no actual difference, then a product differentiation strategy can have the desired effect of creating a preference on the part of customers. A product differentiation strategy requires that a firm be able to effectively communicate with customers through advertising, public relations, sponsoring of events, etc. In fact, advertising usually plays a critical role in an effective product differentiation strategy. Ironically, a firm does not have to be able to create a product with actual differences if it can convince customers that differences exist. Firms that do create products with actual differences have a much easier time convincing customers that those differences exist. Nike’s capabilities lie primarily in design and marketing. The vast majority of Nike’s production of shoes and clothing is outsourced to other firms. Nike’s base of differentiation is not proprietary high-tech manufacturing of superior athletic shoes. Rather, Nike’s base of differentiation is a well-orchestrated marketing effort that has spanned decades.
Slide 5-4 This slide simply offers the definition of a product differentiation strategy.  Teaching Points • Emphasize that the difference in the product must be valued by customers. Difference for the sake of being different is not sufficient. • Remind students that the difference must meet the VRIO criteria (Valuable, Rare, costly to Imitate, and without close Substitutes) in order to create competitive advantage. • Emphasize the point that perception is everything when it comes to product differentiation. Point out that there must be congruence between the firm’s attempts to create a perception and the actual product. If Volvo’s efforts to differentiate itself based on safety are to be successful, its cars must actually be safe. Bases of Differentiation The notion of a base of differentiation is important because it allows a firm to focus its efforts on creating and exploiting a particular difference between its products and competitors’ products. Managers need to understand their own bases of differentiation and the bases of differentiation of competitors so that they can make informed strategic choices.  Important Point: External and internal analysis help managers discover the bases of differentiation of competitors, what bases of differentiation might be valuable in a market, and what bases of differentiation the focal firm might be able to create and/or exploit. Bases of differentiation, thus identified, should be subjected to a VRIO analysis to determine if such bases are likely to lead to competitive advantage—for the focal firm or for competitors. Slide 5-5 Use this slide to demonstrate that there is a wide range of customer needs upon which a firm can differentiate. Drive home the point that differentiation is really a matter of meeting customer needs better than the competing firms. Describe Eleven Bases of Product Differentiation and How They Can Be Grouped into Three Categories Table 5.1 in the text provides a framework for categorizing bases of differentiation. All of these bases of differentiation represent attempts to create preferences for the focal firm’s products and/or services. Three broad categories and the underlying logics of each are listed below. Slide 5-7 Use this slide to briefly introduce the three categories of bases of differentiation. Emphasize that the categories are based on what the focal firm is trying to exploit. Differentiation based on: Attributes of the product or service • preferences are created by actual differences in the tangible product or service offered by the focal firm vis-à-vis competitors’ offerings • product features (Arm & Hammer’s baking soda toothpaste) • product complexity (new digital cameras compared to single use film cameras) • timing of product introduction (release of movies during the holiday and summer seasons) • location (Chevron’s company-owned, combined c-stores & gas stations are situated in prime traffic locations) Slide 5-8 Offer an example of each base of differentiation listed in this slide. Ask students what customer needs each type of base might fill. Relationship between the focal firm and its customers • preferences are created as the focal firm develops and exploits relationships with customers based on what the focal firm’s target customers want • product customization (Dell Computers–customers get exactly the features desired) • consumer marketing (Mountain Dew–changed the image of the product through marketing-product stayed the same) • product reputation (Harley-Davidson Motorcycles–reputation is so strong that some people tattoo the logo on their bodies) Slide 5-9 Offer an example of each base of differentiation listed in this slide. Ask students what customer needs each type of base might fill. Ask students how image advertising (“we’re a good company”) would differentiate soap. Linkages within or between firms • preferences are created as the focal firm combines the competencies of different functions within or across organizations to produce tangible and/or intangible differences between the focal firm’s offerings and those of competitors • linkages among functions within the focal firm (Ford Motor Company’s combination of auto manufacturing and financing) • linkages with other firms (Mattel toys in McDonald’s Happy Meals) • product mix (Cisco’s wide range of Internet technology products) • distribution channels (Coke & Pepsi vending machines) • service and support (Lexus service) Slides 5-10 and 5-11 Offer an example of each base of differentiation listed in these slides. Ask students what customer needs each type of base might fill. Point out that the furniture store on Slide 5-10 is differentiating on product mix by offering things that are also used in the home. This store also offers in-store credit, which entices customers to make more purchases. ► Example: Chrysler Reintroduces the Hemi Engine Chrysler has exploited several bases of differentiation with its reintroduction of the Hemi engine. Reintroduced in 2002, this engine was actually developed in the 1960’s. It was used in Chrysler’s muscle cars in the late 60’s and 70’s. In 1996, an engineering team headed by Robert E. Lee was assigned to develop a high power engine to use in Dodge pickups. At the time, Dodge pickups lagged behind Ford and GM pickups in power. Lee and his team decided to use the old Hemi design, which gets its name from the hemispherical shape of the top of the engines cylinders. This hemispherical shape serves to concentrate the fuel and air at the top of the cylinder. Lee’s team also used two spark plugs in each cylinder. The shape of the cylinder head and the two spark plugs makes the engine much more powerful and efficient than other engines the same size. They also designed the new Hemi to be even more fuel efficient on the highway by shutting down four of the eight cylinders at highway cruising speeds. These product features added very little cost to the engine. Chrysler embarked on a marketing campaign that has met with huge success. This campaign attempts to tap into the nostalgia for the muscle cars of the 60’s and 70’s. Phrases from advertisements like “Well, it’s a Hemi”; “That thing got a Hemi?; and “It’s got a Hemi” have become popular, even among young people who had no idea what a Hemi engine was before the advertisements appeared. The Hemi engine is a pricey option, but customers are clamoring for the engine. On a Dodge Magnum, the Hemi adds about $5,000 to the price tag. Remember, the incremental cost to Chrysler is miniscule. Most of that $5,000 is pure profit. Forty-one percent of the Chrysler 300’s, 46% of Dodge Magnum’s, 72% of the new Dodge Charger’s, and 52% of the Dodge Durango’s are sold with the Hemi. In 2004, Chrysler sold almost 300,000 cars and pickups with the Hemi engine. The company had profits of $1.9 billion in 2004, when Ford and GM had large losses. The Hemi brand became very popular. Chrysler decided to offer the engine in the Jeep Grand Cherokee, but it didn’t put the Hemi badge on the car. Jeep customers began calling Chrysler asking for the badges so they could put one on their cars. In response, Chrysler now puts the Hemi badge on the Grand Cherokee. Subsequently, Chrysler increased the size of the Hemi badge. Chrysler seems to have successfully differentiated its products by combining several bases of differentiation such as product features, links within the organization, reputation, and consumer marketing. Chrysler recognized that the full value of the product feature (Hemi engine) would not be realized without a focus on consumer marketing that played on the reputation of the product feature. Chrysler also realized that the value of the differentiated product could be increased by spreading the product feature and the reputation across multiple car lines (links with the organization). Although Chrysler has downplayed the Hemi name since its acquisition by Fiat, this is an example of a successful differentiation strategy. (Wall Street Journal, 17 June 2005, Power Play: Chrysler’s Storied Hemi Motor Helps It Escape Detroit’s Gloom, by Neal E. Boudette; Wall Street Journal Online, July 7, 2010, Chrysler’s Hemi Engine Loses Favor, by Jeff Bennet and Neal E. Boudette)  Teaching Points • Emphasize that almost any idea can be turned into a base of differentiation. Some of the most effective bases of differentiation are dismissed initially as hair-brained ideas. Who would have thought that customers would drive hours to shop at a fishing and outdoor equipment ‘superstore’ such as Cabela’s? Cabela’s now locates its superstores near interstate highways because it knows it can draw customers from well over 200 miles away. • Point out that a firm’s strategy for a single product may include elements of more than one base of differentiation. For example, Ford Motor Company’s product differentiation efforts often include product features, timing of introduction, location, consumer marketing, reputation, linkages between functions, and product mix. • Drive home the point that a base of differentiation works only if it creates preferences for the focal firm’s products or services. Of course, there has to be a critical mass of customers in whom the base of differentiation creates a preference. Describe How Product Differentiation is Limited Only by Managerial Creativity Almost anything could be a base of differentiation. The key is that some set of customers must find value in the base of differentiation. Everything from tangible product characteristics to abstract intangible concepts like national or regional pride could potentially be a base of differentiation. Managers can create and exploit bases of differentiation from a seemingly infinite number of ideas. For example, “freedom fries” became a base of differentiation among some restaurants as a form of protest against the French who refused to join the U.S. in its war against Saddam Hussein’s government in Iraq. The name change from French fries to freedom fries was the idea of a small but very patriotic restaurateur. This base of differentiation was short-lived as the attention of Americans shifted from the lack of French participation to the war itself. Slide 5-6 This slide shows that there are many possible bases of differentiation. Emphasize the point that managerial insight and creativity is key to creating bases of differentiation. Some people may think an idea for a base of differentiation is nonsense while others may see genius in the same idea. Fred Smith’s idea for overnight delivery that eventually became FedEx was dismissed by a professor as nonsense. Describe How Product Differentiation Can Be Used to Neutralize Environmental Threats and Exploit Environmental Opportunities Slide 5-12 Use this slide to signal to students that you will be taking them through the VRIO model to show them how the model can be used to determine if a product differentiation strategy is likely to generate sustained competitive advantage. VALUE OF DIFFERENTIATION The textbook uses the VRIO Model to explain how product differentiation may be a source of competitive advantage. Students need to understand how product differentiation can create Value for the focal firm. Product differentiation can produce value for a firm by neutralizing environmental threats and/or exploiting environmental opportunities.  Important Point: At this point in the course, students have heard and read about environmental threats and opportunities several times. However, product differentiation deserves close attention because of the large potential for creating value by neutralizing threats and/or exploiting opportunities. Neutralizing Threats. Here is a brief description of how product differentiation can neutralize the threats of the forces mentioned in the environmental threats model along with an example of each one. If the focal firm’s product differentiation strategy is effective: Threat of Entry • would-be entrants face the costs of overcoming customers’ preferences for the focal firm’s products and/or services • Example: Toyota was protected from Hyundai’s entry into the U.S. market because Hyundai had to enter at a low price and advertise heavily to attract customers away from Toyota’s well-established Corolla. Threat of Rivalry • customers have, to some extent, segmented themselves based on their preferences for the products of the several competing firms in a market. Thus, the rivalry is generally lower among firms competing in a market of differentiated products. • Example: Allen Edmonds men’s dress shoes sell for around $360. Most models have thick leather soles that conform comfortably to the foot. Once a customer wears Allen Edmonds shoes, he tends to be very loyal to the brand. Cole Hahn is a competitor at the high end of the market. Some people prefer Cole Hahn, some prefer Allen Edmonds, and once the customer decides on a preference, there is little competition remaining between Cole Hahn and Allen Edmonds. Product differentiation attenuates rivalry for Allen Edmonds because competition for customers is minimized due to customers’ self-selected segmentation. Threat of Substitutes • customers will find the focal firm’s products and services substantially more attractive than substitute products (i.e., customers are less inclined to even try the substitute product and the focal firm is therefore insulated from the threat of the substitute) • Example: Printing digital photographs on a personal printer at home may be viewed as a substitute for professional printing at a photo shop. Photo shops that advertise that their digital prints are superior to what can be printed at home are attempting to create a preference for their product. Shops that successfully convince customers that their product is superior are insulated from the competitive pressure of the in-home substitute. Threat of Suppliers • the power of suppliers may be mitigated in two ways. First, the focal firm will likely be able to pass supplier price increases along to customers who have a preference for the focal firm’s differentiated product (customers with a preference for a differentiated product tend not to be price sensitive). Second, a firm that enjoys the strong preference of customers will usually have more bargaining power with suppliers compared to competitors that do not have differentiated products and services. • Example: Recent spikes in the price of beef are easily passed on to customers of high-end steak houses like Ruth’s Chris and Spencer’s. McDonald’s, Wendy’s, and Burger King’s customers are more sensitive to price increases that make the $.99 burger a thing of the past. Threat of Buyers • the power of buyers is reduced because the focal firm enjoys a quasi-monopoly. By definition, if a firm has a highly differentiated product, then the firm is the only firm in that market that can offer that particular product. Customers with a preference for the focal firm’s products and services must buy from the focal firm, thus reducing the power of buyers. • Daimler-Chrysler’s Crossfire sports car allowed dealers to enjoy a quasi-monopoly as evidenced by the “local market adjustment” (of about $5,000) that dealers were able to tack onto the price of the car. The car was different from other cars and a set of customers had a strong preference for the car. There were a limited number of the cars being built. These factors served to greatly reduce the power of buyers of the Crossfire up until 2008 when the model was discontinued. Slide 5-13 Use this slide to explain how product differentiation can create value by neutralizing environment threats. As you click through the slide, use the examples given above to explain how each of the environmental threat forces can be neutralized by product differentiation. Ask students for other examples of ways that product differentiation can neutralize these threats. Exploiting Opportunities. A product differentiation strategy can be used to exploit opportunities in several different ways. The textbook focuses on how product differentiation can be used to exploit opportunities based on the type of industry in which the focal firm operates. In addition to industry-type opportunities, there are many other opportunities that arise in the external environment that firms can exploit. In a sense, a firm is exploiting an opportunity in the external environment any time it is able to fill some customer need in a new or different way.  Important Point: The value of product differentiation that comes from exploiting an opportunity in the external environment is a function of the benefit the differentiation creates for customers—either real or perceived. Product differentiation may create advantages for the focal firm vis-à-vis competitors, but these advantages all have their roots in benefits to customers.  Important Point: Successful product differentiation results in two important outcomes that generate value for the focal firm. First, customers develop preferences for the focal firm’s products and/or services. Second, when customers perceive a benefit to themselves they become willing to pay a premium for the differences that create that benefit. If the benefit is great enough that customers are willing to pay a price that is above the focal firm’s average total cost, then we can conclude that the product differentiation strategy has created value for the firm. The firm whose customers have a preference for its products and a willingness to pay a premium price for its products is in an enviable position. Slide 5-14 This slide can be used to help students understand the value of product differentiation because of how it allows firms to charge premium prices. The graph on the left represents the demand curve the focal firm would face in a perfectly competitive industry. Point out that price equals the minimum of the average total cost for firms in the industry. The focal firm must accept this price. There are no above normal profits to be had. On the right is a graph representing the demand curve a successful product differentiator would face. Assume that the focal firm is in the same industry as the graph on the left, but that the focal firm has just made a substantial change in product features. As a result, the focal firm now faces a downward sloping demand curve. The first click will show the average total cost for the focal firm. The second click will show the marginal cost curve for the focal firm. The third click will show how price will be set. Price is set at the point on the demand curve directly above the point where marginal cost equals marginal revenue. Point out that even though the average total cost for the focal firm is now a little bit higher than the industry average, the firm can still earn above normal profits because of the premium price it is able to charge. The fourth click will highlight an area representing the above normal profits available to the focal firm. Industry-Type Opportunities Fragmented Industry: • product differentiation through branding can take a commodity-type product and make it a differentiated product • Kellogg’s Corn Flakes is a classic example of this Emerging Industry: • first mover advantages (brand loyalty, switching costs, technology standards, etc.) may accrue to the firm that can quickly differentiate its products in the minds of customers • Motorola did this in the cell phone market. They used their brand equity from the telecommunications and technologies businesses to differentiate their cell phones early. Mature Industry: • firms attempt to differentiate established products by “refining” the product—new and improved • firms may also differentiate a product by offering new levels of service to accompany the product • Ford Motor Company has tried to differentiate the repair and maintenance services offered by its dealers. Auto service is a very mature industry but product differentiation can still be quite valuable to a firm. Declining Industry: • product differentiation in declining industries is usually a matter of moving toward specialization and/or niches • by definition, the number of customers in a declining industry is decreasing and firms recognize that remaining customers must have a strong need to remain customers in the industry—therefore, firms can move to meet those remaining needs in specialized ways • Up until the mid-20th century, hats were an important part of most dress wardrobes. As hats became less popular, hat manufacturing and retailing declined. However, some hat manufacturers and retailers remained in business. These firms typically became very specialized. An example of this phenomenon is the NEWT at the Royal Hawaiian on Waikiki Beach in Hawaii. This small shop sells very high end Panama straw hats and resort attire. Some hats are priced as high as $5,000. These hats are made for a small niche that appreciates the features of these hats. Most people do not place such a high value on a fine hat, but there are some who do and NEWT caters to them. Slides 5-15 and 5-16 Use the examples above to show students how product differentiation can be used to exploit opportunities based on industry type. Explain that a specific product differentiation may be valuable in more than one type of industry. For example, branding can be valuable in any of the types of industry. Other Opportunities in the External Environment Trends or Fads: • firms can provide a differentiated product to satisfy the needs of customers who are responding to trends or fads • custom wheel “spinners” are a current example Government Policy: • changes in government policy can provide many opportunities for firms to develop differentiated products • significant tax incentives exist in the U.S. and Europe for highly efficient automobiles that help make cars like the Tesla, the Toyota Prius, and the SMARTCAR attractive to customers Social Causes: • social causes can create demand for differentiated products that help people further their cause of choice • credit cards issued by causes (in partnership with an issuer) have become a point of differentiation in the credit card business—World Wild Life Fund, alumni associations, etc. Economic Conditions: • almost any economic condition creates opportunities for product differentiation (high unemployment, low unemployment; high interest rates, low interest rates; high inflation, low inflation; etc) • first Hyundai and then Suzuki tried to differentiate their low priced cars by offering the “best” warranties in America in response to stagnating car sales brought on by economic conditions Slide 5-17 Use this slide to discuss other opportunities in the external environment that may be exploited with a product differentiation strategy. Point out that these are four broad categories with only a few of the many possible examples. Ask students for other examples of product differentiation and have students fit them into these or other categories.  Teaching Points • The main point of this section of the class session is that product differentiation can create value for firms in a wide variety of ways. • Emphasize that the value created for the focal firm is really a function of the benefit that customers see in the focal firm’s differentiated product. • Remind students of the importance of ‘preferences’ in creating competitive advantage. Product differentiation is all about creating preferences for the focal firm’s products and services. • Emphasize the concept of customers’ willingness to pay a premium price for a differentiated product. Make the point that a premium price in this context is any price above the average total cost, which would be the price in a ‘perfectly’ competitive market. • Building on the point above, explain that the value of a successful product differentiation strategy lies in the fact that the focal firm is not bound by a ‘perfectly’ competitive market (i.e., it is no longer a price taker). • Point out that a single product differentiation strategy can create value in multiple ways—the categories above are not mutually exclusive. Describe Those Bases of Product Differentiation That Are Not Likely to Be Costly to Duplicate, Those That May Be Costly to Duplicate, and Those That Will Often Be Costly to Duplicate PRODUCT DIFFERENTIATION AND sustained COMPETITIVE ADVANTAGE Having established the Value of product differentiation, we next consider the Rareness and Imitability of product differentiation. The answer to the question of rareness can safely be assumed to be affirmative at this point in the analysis. The assumption is that the focal firm has established a differentiated product, which implies that the product is rare. We therefore turn our attention to the question of imitability. If a product differentiation strategy is costly to imitate, the focal firm can reasonably expect to enjoy a competitive advantage. Slide 5-18 This slide briefly makes the point that rareness is assumed in this analysis. Explain that this is because a differentiated product is rare—it’s different from the offerings of competitors.  Important Point: Remember that the notion of ‘costly to imitate’ means that the cost of imitating the strategy would prove to be greater than the benefit of imitating the strategy. This implies that would-be imitators would rationally choose not to attempt imitation.  Important Point: Only product differentiation strategies based on resources and capabilities that are the result of unique historical circumstances, causally ambiguous, and/or socially complex will be costly to imitate. Slide 5-19 Explain that the logic and sources of costs of imitation are the same as what they have seen in earlier chapters. Emphasize the point that managers need to carefully analyze potential sources of cost of imitation, whether they are trying to establish, defend, or imitate a differentiated product. Based on this logic, the textbook categorizes the bases of differentiation discussed earlier into three groups: bases that are easily duplicated, bases that may be costly to imitate, and bases that are usually costly to imitate. The bases are listed below under the appropriate category along with the logic as to their categorization. Easy to Duplicate Product Features • are easy for competitors to observe • unless there is a patent, competitors face little cost in imitation • may lead to temporary competitive advantage until competitors are able to imitate • Example: Wrinkle-free, 100% cotton in shirts, blouses, and pants is a product feature that has been rapidly duplicated. This innovation meant that customers could enjoy the feel of 100% cotton without having to iron or professionally launder their clothing. Nordstrom was an early adopter with its SmartCare line. Most other department stores now have their own line of all cotton clothing that is wrinkle-free. May be Costly to Duplicate Product mix Links with other firms Product customization Product complexity Consumer marketing • these bases all entail a relationship and/or the need for coordination • if any of these relationships and/or coordination efforts are marked by unique historical circumstances, causal ambiguity, or more likely, social complexity, then it may be costly for other firms to imitate these relationships • Example: iTunes is part of Apple’s product mix. iTunes depends on links with several other firms in the music, entertainment, and technology industries. The product is customizable and, to some extent, complex. Consumer marketing is definitely a part of the iTunes strategy. As time goes on, the iTunes model is becoming increasingly costly to imitate as these relationships and coordination efforts mature. Customers face switching costs that imitators would have to overcome. • these relationships could exist without being historically unique, causally ambiguous or socially complex, in which case, they could be easily imitate Usually Costly to Duplicate Links between functions Timing Location Reputation Distribution channels Service and support • all have the common element of uniqueness in some way, most of the time (specific linkages can exist only in the focal firm, there is only one ‘first mover’, there is only one prime location, there is only one firm reputation, etc.) • in many cases, it would be impossible for a competitor to duplicate the base of differentiation • links, reputation, distribution channels, and service and support all depend on relationships • these relationships are usually marked by historical uniqueness, social complexity, and often by causal ambiguity—making it very costly for competitors to duplicate the relationships • differentiated service and support is usually the result of social complexity within the firm and between firm employees and customers • the relationships that lead to happy employees, that in turn lead to happy customers through differentiated service are costly, if not impossible, to imitate ► Example: What is the first brand name that comes to mind when you hear the phrase “high quality watch”? Rolex is the answer most people give. The product differentiation that Rolex enjoys initially stemmed from several bases, including product features, timing, location, reputation, distribution channels, and service and support. Reputation appears to be the most enduring of these. Other watch makers have achieved comparable quality and product features. Other watch makers use nearly identical distribution channels and offer comparable service and support. And yet, Rolex seems to enjoy a reputation that exceeds all others. Certainly, the other bases of differentiation feed into the reputation of Rolex. Barring some egregious strategic misstep it appears that Rolex will continue to enjoy a successful product differentiation strategy based on its reputation. Slide 5-20 Explain the logic above as you click through this slide. Emphasize the fact that bases of differentiation that may be costly to imitate are based on relationships. If those relationships are marked by historical uniqueness, causal ambiguity, and/or social complexity, the bases will be costly to imitate. Most of the bases that are listed as usually being costly to imitate have an inherent element of uniqueness. Describe the Main Substitutes for Product Differentiation Strategies Substitutes The ability of a base of differentiation to generate a competitive advantage also depends on the proximity of close substitutes. One base of differentiation may be a substitute for another base of differentiation. There is constant competition among firms to create customer preferences for their respective products. For example, for several years WordPerfect was the undisputed market leader in word processing software. WordPerfect was loaded with innovative product features that were superior to competitors’ offerings. Microsoft began to bundle its Word product with Excel, PowerPoint, and Outlook. Users could seamlessly cut and paste from one program to another. Microsoft’s bundling was a substitute for WordPerfect’s product features. Eventually, Microsoft’s bundled products became the undisputed market leaders. Although some substitutes may be apparent in a market, many substitutes for a differentiated product may ‘pop up’ in the marketplace at any time. Managers should monitor the environment for potential substitutes. Bases of differentiation may need adjustment in order to keep potential substitutes from becoming close substitutes. Slide 5-21 Point out that managers should look for substitutes, but bear in mind that even if no substitutes are apparent, others will be tempted to imitate a valuable base of differentiation.  Teaching Points • Make the point that a careful analysis of the costs of imitation is important from three points of view: 1) the firm contemplating developing a product differentiation strategy, 2) the firm seeking to defend its existing differentiated product, and 3) the firm contemplating the imitation of a differentiated product. • Remind students of what costly to imitate really means so that they understand why would-be competitors will rationally avoid attempting to imitate bases of differentiation that are costly to imitate. • Emphasize the logic of historical uniqueness, causal ambiguity, and social complexity in making a base of differentiation costly to imitate. • Encourage students to recognize that some bases of differentiation will provide temporary competitive advantage and other bases will offer sustainable competitive advantage. • Point out that managers can wield a degree of influence in making some bases of differentiation more costly to imitate. For example, managers can focus on offering superior service and support by exploiting socially complex relationships within the firm. Describe How Organizational Structure, Control Processes, and Compensation Policies Can Be Used to Implement Product Differentiation Strategies IMPLEMENTING A PRODUCT DIFFERENTIATION STRATEGY The Organization question of the VRIO Model is perhaps even more important with a product differentiation strategy than with a cost leadership strategy because of the relationship between the focal firm and customers. A successful differentiation strategy depends on creating customer preferences for the products and/or services of the focal firm. Customer preferences are heavily influenced by customers’ experiences in interacting with the focal firm. The focal firm must be able to respond quickly and accurately to customer needs. Customers need to ‘feel’ that the focal firm is catering to their needs. Organizational structure, management control systems, and compensation policies can all be managed to encourage customers to have a preference for the focal firm’s products and/or services. Organizational Structure At the business level, the U-Form is used to implement product differentiation strategies just as it is to implement cost leadership strategies. However, there are some important differences in the way the structure is used. The U-Form is used in a cost leadership strategy to exploit the efficiencies inherent in the structure due to specialization. With a product differentiation strategy, the specialization of the U-Form structure is exploited through cross-functional teams. ► Example: The Cross Functional Design of the Ford Taurus The Ford Taurus was developed using cross-functional teams. At the time of its introduction in December of 1985, the Taurus was an extremely differentiated product because it was a radical design departure from the boxy American cars of the 70’s and 80’s. Auto companies usually left the design of a car to the product engineers. The design was then given to process engineers to figure out how to build the car. Finance and marketing people were also shown the design and charged with figuring out how much the car would cost to build and how to market the car to customers. However, with the Taurus, Ford brought product engineers, process engineers, finance managers, and marketing managers together at the beginning of the design process. Ford took the cross-functional team concept a step further by including engineers from its European operations. Many credit the inclusion of these European engineers for the bold departure from the squared-off cars that Detroit had been producing for years. Process engineers were able to influence the design so that the car could be built more efficiently. Finance people were able to minimize the cost of the car by suggesting efficiencies along the way. Marketing people were also able to influence the design of the car based on their feel for the market. The Taurus LX was Motor Trend’s car of the year in 1986. The Taurus was the best selling car in America from 1992-1996. Ford’s cross-functional design team on the Taurus was a huge success. Ford adopted this design approach for other cars. The Ford Windstar was the first car that was designed primarily for a female buyer. The marketing people on the team recognized that more than 80 percent of buying decisions were made by female buyers.  Important Point: Cross-functional teams within the U-form (functional) structure can be exploited to an even greater degree by dedicating the team to the development of a single, highly differentiated product. This is sometimes done by creating a ‘skunk works’ in which the team is separated from the normal operations of the firm. Management Controls The main idea behind using management controls in the implementation of a product differentiation strategy is that of flexibility. Not only must managers and employees have the freedom to be flexible, they should also be encouraged to be creative and adaptable. Decision-making is usually more decentralized in a product differentiation strategy as compared to a cost leadership strategy. This decentralization means that managers can make decisions and take actions that allow the focal firm to differentiate its products and/or services through a high degree of responsiveness to customers. As a matter of firm policy, decision-making guidelines are broader—allowing greater flexibility. Also, managers and employees should explicitly be given the freedom and encouragement to experiment with new ideas. Managers and employees need to know that if experimentation leads to failure, they will not be punished for having tried. Compensation Policies Compensation policies can be used to help exploit the U-form structure and reinforce the broader management controls discussed above. In the simplest of terms, compensation policies should be structured to reward managers and employees for cooperating within cross-functional teams and being creative in the process. Compensation policies can be especially effective with regard to experimentation and risk taking. Promised rewards for successful experimentation and the promised absence of punishment for failed experimentation provide strong incentive to be creative.  Important Point: If the focal firm is changing to a product differentiation strategy from a cost leadership strategy or adopting a product differentiation strategy for a new product, the incentives created by a compensation policy must be considered carefully. For example, the base upon which bonuses and/or stock options are determined will most likely need to be changed. A functional manager’s reward based on reducing cost within a single function may provide an appropriate incentive in a cost leadership strategy. In a product differentiation strategy, that same functional manager may be more appropriately rewarded based on the success of a cross functional team in developing a new product. Slide 5-22 Use this slide to discuss how organizational structure, management controls, and compensation policies can be used to implement a product differentiation strategy. Emphasize that the U-form is used, as is done with a cost leadership strategy, but the efficiency of the structure is exploited in a different way, namely, through cross-functional teams. Also, remind students that rewards are used to reinforce structure and management controls.  Teaching Points • Emphasize that although the U-form (functional) structure is used to implement both a product differentiation strategy and a cost leadership strategy, the characteristics of the U-form are exploited in very different ways. • Point out that cross-functional teams exploit the specialization of the U-Form by bringing experts, due to specialization, together to solve problems and/or create new products. • Remind students that organizational structure, management controls, and compensation policies should all be compatible and mutually reinforcing. Discuss Whether or Not It Is Possible for a Firm To Implement Cost Leadership and Product Differentiation Strategies Simultaneously, and Why or Why Not PURSUING PRODUCT DIFFERENTIATION AND COST LEADERSHIP STRATEGIES For years, management scholars have debated whether firms can simultaneously pursue cost leadership and product differentiation. Students often ask the same question. One question that usually arises in discussions of product differentiation is: When a store advertises its low prices like Wal-Mart does, is that evidence of a cost leadership strategy or is that evidence of a product differentiation strategy? The answer is: Yes. Most firms’ strategies contain elements of both cost leadership and product differentiation. But, in the vast majority of firms one is clearly emphasized over the other. The relatively few firms that can effectively pursue both strategies are in an enviable position indeed. Table 5.5 lists the different organizational structure, management control, and compensation policy approaches to implementing cost leadership and product differentiation strategies. At first glance, the two columns may appear to be opposites. However, with some adjustment, managers can blend most elements found in the two columns. Anecdotal evidence suggests that firms that are able to simultaneously pursue both strategies started out with a sharp focus on one, and in time were able to pursue the other as well. Conversely, anecdotal evidence also suggests that some firms that have tried to do both and failed weren’t really achieving one before they started to pursue the other. Here are some quick examples from the discount retail market and the auto industry: Wal-Mart started out with a sharp focus on cost leadership. This strategy allowed them to gain market share and become very profitable. In time, the firm could afford to advertise heavily to convince customers that they had the low price. Always. This heavy advertising is indicative of a product differentiation strategy. It is also interesting to note that local store managers, although obligated to follow fairly strict guidelines, are able to carry items of local interest that are not part of the national buying program. Toyota developed a manufacturing system that drove costs to a minimum. Toyota recognized that they could achieve low manufacturing costs and very high quality simultaneously with their system. Most American consumers initially viewed Toyota as a low cost alternative to higher priced American cars. In time, Toyota began to differentiate its products on quality. Its Lexus line is very much a differentiated product that is manufactured at a very competitive cost among luxury carmakers. Mercedes developed a strong reputation for high quality cars. For many years, cost was not a critical issue for Mercedes. The introduction of car lines like the Lexus and the rising popularity of SUVs have forced Mercedes to focus more on cost. In other words, Mercedes is being forced to be concerned about cost. It remains to be seen if Mercedes will become competitive on cost or if Mercedes will further differentiate its cars on quality. Some industry analysts worry that Mercedes may hurt its reputation for quality if it tries to focus on cost too much. Ford very successfully introduced the Taurus as described above. However, in 1996, Ford tried to move the Taurus up market. Other carmakers had imitated many of the Taurus’ most distinguishing features. Ford tried to differentiate the Taurus with an even more ‘rounding’ of the body. The sticker price was raised about $2,500. This attempt to differentiate the Taurus was a failure. Many customers turned to the Toyota Camry and the Honda Accord. By 1996, the Taurus wasn’t a cost leader and it wasn’t highly differentiated. It seems to have become stuck in the middle. K-Mart tried to differentiate itself by moving upscale in the mid-1990s. Having realized it couldn’t compete with Wal-Mart on price, K-Mart seems to have decided to adopt a level of differentiation. Celebrities such as Kathy Ireland and Martha Stewart were used to try to generate more sales in clothing and household goods, respectively. Stores were remodeled. Many were converted to “Big K” stores. Several years of financial performance, including a bankruptcy (and a merger with Sears), suggest that this attempt at differentiation did not work. K-Mart seems to have tried to abandon cost leadership in favor of differentiation. In the end, it seems to have become stuck in the middle. Slide 5-23 Use this slide to guide your discussion of the simultaneous pursuit of cost leadership and product differentiation. Be careful not to spend too much time on this slide if you are going to use the Discussion & Activity below. Be sure to emphasize that evidence suggests some firms can pull it off, but most cannot. After using the Rolex and Toyota examples, ask students why the difference between the two firms. Is it a matter of firm capabilities or is it a matter of different bases of differentiation? It is both.  Teaching Points • Point out that although cost leadership and differentiation are usually presented as two extremes, they are not necessarily mutually exclusive. • Emphasize that the two strategies can be successfully pursued simultaneously only when the base of differentiation is compatible with cost leadership. (If the base of differentiation is customization and therefore the quantity of any one product will never be more than a few units, it is unlikely that the firm will ever achieve cost leadership, unless the market is defined as the market for such customized products.) • Use the Discussion and Activity below to help students develop their thinking about cost leadership and product differentiation. Discussion & Activity: Cost Leadership vs. Differentiation Divide students into groups of about five students each. Ask students to identify three firms within an industry of their choosing as follows: one firm that seems to be focusing on cost leadership, one firm that seems to be focusing on product differentiation, and one firm that seems to be doing both. Suggest that airlines, clothing retailers, discount retailers, and automobiles are industries in which it is rather easy to find three such firms. Now ask students to develop a list of their reasons for choosing each firm. Be sure to allow a few minutes for them to discuss these reasons. Choose a group to share their list of firms and their reasons for each firm. Now ask students to discuss within their groups whether the cost leader on their list could also become a differentiator. Could the differentiator become a cost leader? Have a group share the results of their discussion with the class. Challenge this group’s answers whether they answer affirmatively or negatively. Ask them to compare their answers to the firm they identified as being able to do both. What are the similarities and differences between firms that suggest that firms could or could not pursue both strategies simultaneously? The main points that should emerge from this discussion are: • history matters because customers have a view of what a firm is and what it should be—it’s difficult to change these perceptions • there must be nearly perfect alignment among organizational structure, management controls, and compensation policies— and they must simultaneously facilitate both strategies • there seems to be an element of both strategies in most firms’ strategies • managers and employees may have to change the way they behave in order to pursue the other strategy along with the one they are already pursuing • such a change is non-trivial—it would be difficult, but the rewards for doing so are significant • most firms cannot successfully pursue both strategies • there is increasing pressure for firms to pursue both strategies SUMMARY OF PRODUCT DIFFERENTIATION The main points from this discussion that students need to understand are: successful product differentiation means that customers have a preference for the focal firm’s products and/or services customers’ preferences will lead them to pay a premium price for the focal firm’s products and/or services there are many possible bases of differentiation—in fact, almost anything could be a base of differentiation product differentiation may lead to competitive advantage if the base of differentiation meets the VRIO criteria the value of a base of differentiation can be manifested by limiting a threat and/or exploiting an opportunity in the external environment some bases of differentiation are easy to duplicate, some may be costly to duplicate, and some are usually costly to duplicate a successful product differentiation strategy depends on the appropriate implementation of the strategy with respect to organizational structure, management controls, and compensation policies firms can simultaneously pursue both cost leadership and product differentiation strategies but it is difficult to do Slides 5-24 and 5-25 Use these slides to make the teaching points below. In the slide show view, after the second click, you’ll see a button on the right. That button will take you to a slide showing the pricing graph. On the bottom of the pricing graph slide is a return button that will bring you back to this summary slide.  Teaching Points • Emphasize that the whole point of product differentiation is to create customer preferences for the focal firm’s products and/or services. • Show students the pricing graph according to the instructions in the slide box above to drive home the point that differentiated products command higher prices and generate above normal profits. • Make sure students understand that almost anything can be a base of differentiation. • Point out that a base of differentiation can lead to competitive advantage if it meets the VRIO criteria. • Remind students that the whole idea of differentiation can be applied to their professional and personal lives. If they can make themselves stand out from the crowd in some positive way, they will get noticed and rewarded. Instructor Manual for Strategic Management and Competitive Advantage Concepts and Cases Jay B. Berney, William S. Hesterly 9781292060088, 9781292258041

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