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DAVID L. AGER
MICHAEL A. ROBERTO
Trader Joe’s
In July 2013, Market Force Information released the results of a new study in which over 6,000
Americans ranked their favorite supermarkets in a variety of categories. Trader Joe’s ranked No. 1
overall.1 Consumer Reports ranked Trader Joe’s the second-best supermarket in the country in 2012.2
One year earlier, Fast Company named Trader Joe’s the 11th most innovative firm in the U.S.3
Hundreds of people waited in line for the doors to open on March 22, 2013 at the grand opening
of Trader Joe’s in Columbia, South Carolina. Local police directed traffic, and people hunted for
parking at nearby businesses because they couldn’t find a spot in Trader Joe’s parking lot.4
Customers arrived at 3:00 a.m. on June 29, 2012, to line up for the opening of a new Trader Joe’s in
Lexington, Kentucky.5 That same scene played out at new store openings around the country. Job
seekers flooded the firm with applications when they learned of a new store. Meanwhile, retail
experts marveled that the quirky grocer generated much higher sales per square foot than any of its
rivals.
With all that success, Trader Joe’s had attracted imitators. Tesco, the world’s third-largest retailer,
had launched a chain of small neighborhood markets in the western United States. The British firm
appeared to borrow extensively from the Trader Joe’s concept with its Fresh & Easy stores. In April
2013, Tesco announced that it was withdrawing from the U.S. market, hoping to find a buyer for its
approximately 200 stores. The British retailer recorded a $1.8 billion loss associated with its failure in
the U.S. market.6
Tesco’s troubles did not discourage other retailers from introducing smaller-footprint stores. WalMart, the world’s largest retailer, had experimented with its Neighborhood Markets concept since
1998. These smaller grocery stores differed from traditional Wal-Mart supercenters in size and
product variety. They were roughly 38,000 square feet in size and only offered grocery and pharmacy
items. The Neighborhood Markets concept had evolved over the years and recently began to show
promising results. In 2011 the firm launched Wal-Mart Express, a 12,000–15,000-square-foot store that
the company described as a “bit of a hybrid between a food, pharmacy and convenience store.” The
first 10 stores turned profitable in one year. 7
In May 2013, Wal-Mart announced strong comparable store sales growth at these smaller
locations, and the firm indicated that 40% of new store openings over the next year would come in
the small-format category. In 2013, it planned to open over 100 small-format stores. The head of WalMart’s U.S. business, Bill Simon, declared at an industry conference, “You’ll see us increasingly
moving into smaller formats. They compete really well against multiple channels.”8 Many other
________________________________________________________________________________________________________________
HBS Senior Fellow David L. Ager and Michael A. Roberto, Trustee Professor of Management at Bryant University, prepared this case. This case
was developed from published sources. Funding for the development of this case was provided by Harvard Business School, and not by the
company. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary
data, or illustrations of effective or ineffective management.
Copyright © 2013, 2014 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-5457685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be
digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
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retailers, including Target, Kroger, Giant, Tops, and Publix, had launched smaller-format
experiments as well. Meanwhile, Amazon continued to make a push into the grocery business. In
June 2013, Amazon expanded its online grocery service outside of Seattle for the first time, with an
entry into the Los Angeles market. Experts predicted that Amazon would introduce the service in San
Francisco later in the year and as many as 20 additional cities in 2014.9 As the onslaught of new
competition emerged, Trader Joe’s had to consider how it might adapt to cope with these threats.
Company History
Joe Coulombe grew up in San Diego, California during the Great Depression. After completing his
MBA at Stanford in 1954, Coulombe took a job with Rexall, a North American drugstore chain. While
working there, he launched a convenience store chain called Pronto Markets in 1958. Coulombe
eventually acquired the small chain from Rexall and branched out on his own. He secured financing
from Adohr Milk Farms. However, 7-Eleven acquired Adohr Milk Farms in 1965. The dominant
player in the convenience store industry now owned Coulombe’s source of capital, which he found
untenable. Coulombe shifted his strategy and founded Trader Joe’s in 1967. He explained the origins
of the concept:
Scientific American had a story that of all people qualified to go to college, 60% were going.
I felt this newly educated—not smarter but better-educated—class of people would want
something different, and that was the genesis of Trader Joe’s. All Trader Joe’s were located
near centers of learning. Pasadena, where I opened the first one, was because Pasadena is the
epitome of a well-educated town. I reframed this: Trader Joe’s is for overeducated and
underpaid people, for all the classical musicians, museum curators, journalists—that’s why
we’ve always had good press, frankly! 10
Trader Joe’s offered products aimed at the sophisticated consumer interested in finding good
bargains. The store tried to offer products (such as whole-bean coffees, sprouted wheat bread, and
black rice) not typically found at supermarkets. The environmental movement had caught
Coulombe’s eye during those early years, which prompted him to sell many natural and organic
foods. Soon the company began offering private label items. The first private label product, granola,
launched in 1972.11 In the ensuing years, Trader Joe’s offered an extensive line of private label items
with brand names such as Trader Joe’s, Trader Ming’s, Trader Jose, Trader Giotto, and the like.
Interestingly, Coulombe also experimented with a variety of nonfood items, ranging from music
albums to pantyhose. In addition, trying to cater to the educated, sophisticated customer, Coulombe
chose to offer a wide selection of California wines. The wine became a focal point in the ensuing
years, while the albums and pantyhose disappeared from the store’s shelves.
The stores tended to be quite small, less than 10,000 square feet in many cases. Trader Joe’s
stocked far fewer items than a typical supermarket. All of its stores adopted a South Seas theme:
Coulombe remembered, “I read that the 747 [Boeing jumbo jet] would radically reduce the cost of
travel, and I came up with the term ‘Trader’ to evoke the South Seas. The first stores were loaded
with marine artifacts.”12 Coulombe also outfitted the employees with Hawaiian shirts. The store
manager became known as the “Captain” of that location, with a “First Mate” serving as his or her
assistant.
Coulombe believed strongly in paying employees a good wage. He decided that his average fulltime employee should earn the median family income for the state of California—$7,000 per year at
the time the company was founded. He said, “What I keep telling people [is] forget about the
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merchandise; it’s the quality of the people in the stores.”13 He took great pride in the fact that many
employees loved working there and stayed for years.
The company eschewed traditional supermarket advertising, such as coupon-filled circulars in the
Sunday newspaper or television commercials. Instead, it distributed a customer newsletter, which
came to be known as the “Fearless Flyer.” The newsletter provided information on certain products
and introduced new items. It did not offer sales and promotions, however. Instead, the company
embraced an “everyday low-pricing” philosophy. Coulombe also recorded many short radio ads in
which he would tell behind-the-scenes stories about various products. Early commercials were
broadcast on KFAC, a classical music station based in Los Angeles.14
The Aldi acquisition Coulombe pursued a very deliberate growth strategy: during his 20year tenure as CEO, he typically opened roughly one store per year. He did so without ever straying
from the Southern California region. In 1979, German grocer Theo Albrecht, who owned one of
Germany’s most successful grocery chains—Aldi North—became enamored with the Trader Joe’s
concept, and acquired the company. Coulombe agreed to remain as CEO, a position he held until
1988. Albrecht ran a lean low-cost operation with minimal overhead. His discount grocery stores bore
a strong resemblance to the Trader Joe’s business model, minus the South Seas theme and a concerted
focus on cultured, urbane consumers. Aldi North sold mostly private label goods at low prices,
stocked far fewer items than a typical supermarket, and maintained a fairly small footprint. It also
carried a small amount of fresh fruits and vegetables. Theo’s brother, Karl, owned a sister chain, Aldi
Sud, which would eventually open small-footprint discount grocery stores in the United States. As of
July 2013, Aldi Sud operated over 1,000 stores across 31 states. 15 Together, the two Aldi chains
operated roughly 10,000 stores around the globe. 16 Many experts attributed Wal-Mart’s exit from the
German market in 2006 to its failure to match Aldi’s combination of merchandising prowess and
operational efficiency.
Albrecht gave Coulombe a great deal of autonomy to continue running Trader Joe’s as he wished,
and executives from Germany visited the Trader Joe’s headquarters in California only once per year.
However, Trader Joe’s adopted Albrecht’s obsession with secrecy. Theo and Karl Albrecht
maintained very private lives—so much so that German newspapers had a difficult time finding a
photograph of Theo when he died in 2010.17 Consistent with Albrecht’s philosophy, Trader Joe’s did
not have signs with the company’s name or logo at its headquarters in Monrovia, California. Further,
company executives almost never talked to the media. And the company’s website remained very
simple, with little information about the company’s strategy, leadership team, or financial success.
The site did not even have a timeline of the firm’s history until 2009.18
New leadership Coulombe stepped down as CEO in 1988 and was replaced by fellow
Stanford graduate John Shields. Under the new CEO’s leadership, Trader Joe’s expanded beyond its
Southern California base. The company opened its first locations in Northern California in 1988, and
expanded to Arizona in 1993. The next big move entailed the opening of locations on the East Coast.
Trader Joe’s chose Brookline, Massachusetts—a suburb of Boston—as the site of its first East Coast
store.19 The Boston area, of course, had more universities than virtually any metropolitan area in the
country.20
Trader Joe’s began selling its now-famous private label wines in 2002. The wines—sold under the
brand name Charles Shaw Winery—became a huge hit with customers. They affixed the name “Two
Buck Chuck” to the wine, because it sold for $1.99 per bottle in California ($2.99 on the East Coast).
Soon, Charles Shaw wines had become a classic example of “cheap chic.”21
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Trader Joe’s expanded to the Midwest in 2000, opening stores in the Chicago area. On St. Patrick’s
Day in 2006, the company opened its first store in Manhattan. Soon thereafter, Trader Joe’s made its
debut in the southeastern part of the United States. The stores remained fairly low-tech during this
time. The company did not even introduce price scanners at the checkout lines until 2001, and it
continues to eschew self-checkout to this day. In 2001 Shields stepped down as CEO; by that time, the
chain had grown to 175 locations. Dan Bane succeeded him as chief executive, and was still the
company’s leader as of 2013. Trader Joe’s remained a privately held company, owned by an Albrecht
family trust since Theo’s death in 2010.22
The Supermarket Industry
Wal-Mart, Kroger, Safeway, and Supervalu were the four largest grocers in the United States. 23
(See Exhibit 1 for a list of the top grocers in the country.) Supermarkets traditionally operated on
very thin profit margins, and they faced increasing challenges in 2013. Many traditional supermarket
chains found themselves squeezed between premium players such as Whole Foods at the high end of
the market, and “hard discounters” such as Dollar General and Aldi at the low end.24 (See Exhibit 2
for details on the financial performance of several grocery retailers.)
Whole Foods Market ranked as the nation’s leading retailer of organic and natural foods. The
company operated more than 330 stores in the United States, Canada, and the United Kingdom.
Stores averaged roughly 38,000 square feet. Whole Foods locations typically carried 21,000 stockkeeping units (SKUs). Two-thirds of its sales consisted of perishable items, including bakery and
prepared foods. That percentage ranked much higher than most supermarkets in the country. In 2012
Whole Foods achieved 8.4% same-store sales growth. Over the past decade, the company had
benefited from robust growth in natural and organic food sales in the United States. 25
Meanwhile, Dollar General operated the largest number of small discount stores in the United
States, with over 10,000 locations in 40 states. Dollar General’s stores typically carried approximately
10,000 SKUs (mostly simple necessities such as laundry detergent, paper towels, socks, etc.) and had
7,200 square feet of selling space. The average customer completed a shopping trip in roughly 10
minutes. The company reported same-store sales growth of 4.7% in its 2012 annual report.26
Supermarkets had faced another major challenge in recent years. Their share of grocery sales in
the United States fell to 51% in 2011. Just a decade earlier, supermarkets had accounted for two-thirds
of all grocery sales in the nation. But supermarkets lost ground as large discount retailers (Wal-Mart,
Target), warehouse clubs (Costco, BJ’s, Sam’s Club), and pharmacy chains (CVS, Walgreen’s)
increased their emphasis on grocery sales.27
Wal-Mart had become the largest grocery retailer in the nation. The company operated over 3,000
supercenters throughout the U.S. These supercenters had an average of 185,000 square feet and
carried over 100,000 SKUs. Supercenters sold groceries as well as general merchandise, including
apparel, electronics, home goods, hardware, toys, and more. In 2012 Wal-Mart’s grocery revenues
exceeded $100 billion. Wal-Mart’s highly efficient operations enabled it to take share from traditional
supermarkets by dropping prices significantly. 28 While Target did not operate nearly as many
supercenters as Wal-Mart, the company had recently expanded its food section dramatically at stores
throughout the country. By 2013, groceries accounted for nearly 20% of Target’s revenue. Like WalMart, Target found that grocery sales drove store traffic, leading to increased sales of higher-margin
items such as apparel and electronics.29
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As a result of these trends, many traditional supermarket chains found themselves shedding
employees in order to become more cost competitive. Several experienced financial distress. The
Great Atlantic and Pacific Tea Company (known as the A&P brand) had filed for bankruptcy
protection in December 2010. Supervalu, which operated chains such as Jewel and Albertson’s,
suspended its dividend in July 2012 and hired Goldman Sachs and Greenhill & Co. to examine
strategic options for the business. 30 In January 2013, Supervalu sold five of its grocery chains to
private equity investors, cutting the size of the company roughly in half.
Trader Joe’s in 2013
By 2013, Trader Joe’s had expanded to approximately 400 locations across 37 states and the
District of Columbia. Of the 414 stores currently open or set to open in the coming year, 172 were
located in California (see Exhibit 3 for a list of stores by state). Illinois ranked second, with 20
locations. The top five states accounted for 60% of the company’s stores.31 Experts estimated that
Trader Joe’s generated approximately $10 billion in annual revenue. 32 The company did not disclose
financial results, but most analysts believed that it achieved higher returns on investment than most
supermarkets in the nation. Experts noted that while Whole Foods Market had the highest sales per
square foot of any publicly traded grocer in the country, Trader Joe’s doubled the sales per square
foot achieved by Whole Foods (see Exhibit 1 for data on the top chains in the country).33
Store operations Many Trader Joe’s stores could be found in old strip malls in suburban
locations. The typical Trader Joe’s store had less than 15,000 square feet of selling space. Many early
locations maintained footprints of approximately 10,000 square feet. The typical supermarket ranged
in size from 40,000 to 50,000 square feet. As a result, Trader Joe’s did not have the wide aisles that
existed in many supermarkets. Writer Dave Gardetta explained the logic of the quirky, cramped
layout of the stores:
This “chevron” pattern is used in all Trader Joe’s stores, aisles canting left. . . . The offbeat
floor arrangement complements Trader Joe’s unregimented persona: “Hey, we just threw up
some shelves, and there they are.” It’s also a retail trick. Angled passageways reveal a store’s
contents in profile to arriving shoppers. Rows squared with the walls (see: any supermarket)
inadvertently conceal their contents from customers peering into a corridor’s mouth looking
for the toothbrush display.34
Checkout lines could be quite long at Trader Joe’s during busy Saturday mornings, and parking
lots tended to be quite crowded. One Los Angeles area blogger complained about it:
I love Trader Joe’s for their prices, for their Joe-Joe’s, for their simmering sauces. But, all the
mushy love I have for Trader Joe’s is nearly outweighed by how much I hate it for having
absolutely awful parking lots. If you don’t live near one of their new and improved stores—
i.e., the ones at Hollywood and Vine or Olympic and Barrington—then you’re stuck with an
archaic lot that is a one-way traffic jam from hell. This is my list of the 5 Worst Trader Joe’s
Parking Lots in LA.35
Trader Joe’s did not invest a great deal in technology within the stores. The company did not offer
self-checkout lanes, and it did not have flat-screen TVs at the checkout counter. CEO Dan Bane joked
about those televisions at rival retailers, noting that Trader Joe’s customers had the opportunity to
actually talk to employees.36
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Merchandising
Trader Joe’s carried about 4,000 SKUs per location, as compared with as
many as 50,000 units for most grocery stores. Eighty percent or more of the products in a Trader Joe’s
store consisted of private label items. (Typical supermarkets generated less than 20% of their sales
through private label goods.) Because of this, customers could not find many of the major brands at
Trader Joe’s. If customers wanted Cheerios cereal or Coca-Cola beverages, they had to go elsewhere.
Nor did Trader Joe’s offer a wide selection of fresh meat or produce. Instead, it featured an extensive
frozen food collection. It also tended to sell fruit by the piece rather than by the pound. Beth Kowitt
of Fortune visited one of the company’s Manhattan stores and commented, “Make no mistake: A
typical family couldn’t do all its shopping at the store. There’s no baby food, toothpicks, or other
necessities. But for this crowd of urbanites and college kids, Trader Joe’s is nirvana.”37
Trader Joe’s buyers scoured the globe for interesting new products and tried not to follow trends.
Instead, they tried to identify new products that customers had not experienced previously. They also
avoided trade shows, which featured products that every other retailer could see. Because the
company stocked limited varieties of each product, its buyers purchased very large quantities of each
SKU at low prices. This enabled them to purchase goods directly from manufacturers, rather than
working through distributors or wholesalers. Trader Joe’s did not charge suppliers to slot their
products on the retailer’s shelves, unlike many rivals. Moreover, the company paid its suppliers
promptly, rather than trying to stretch out its accounts payable for as many days as possible. 38
Trader Joe’s maintained a dynamic product mix that made shopping at the store feel like a
treasure hunt. Merchants strove to introduce 10–15 new products per week. As a result, they had to
eliminate 10–15 products each week. Some changes occurred because special seasonal items were
introduced or discontinued. In other cases, the buyers ruthlessly cut products that did not meet sales
goals. Employees became adept at consoling customers searching for discontinued products. 39
Coulombe explained how he pursued a scarcity strategy quite deliberately:
I learned that lesson with vintage wines. There’s only so much 1966 Lafite Rothschild. So
we deliberately pursued a policy of discontinuity, as opposed to, say, Coca-Cola, which is in
infinite supply. For example, we had the only vintage-dated, field-specific canned corn in
existence, and it was the best damned canned corn there was. But there was only so much
produced every year, and when you’re out, you’re out.40
The company required its vendors to maintain complete secrecy about their relationship with the
retailer. Trader Joe’s did not want rivals or customers to know how and where it sourced its private
label goods. Suppliers often wanted complete secrecy as well, because they were providing Trader
Joe’s a much lower-cost version of their branded product, which might be selling at higher prices at
Whole Foods or other retailers. Occasionally reports did surface in the media about Trader Joe’s
vendor relationships, and reporters questioned how unique some Trader Joe’s products really were.
For instance, Fortune reported that Stonyfield Farm supplied Trader Joe’s yogurt on the East Coast,
and Pepsi’s snack division produced the retailer’s line of pita chips. 41
Customers Trader Joe’s claimed that 80% of its customers had attended college. The company
described its target market as “intelligent, educated, inquisitive individuals.”42 It focused on people
who were health conscious, enjoyed travel, and liked trying new things. Tony Hales, a store captain,
described the clientele: “Our favorite customers are out-of-work college professors. Well-read, welltraveled, appreciates a good value.”43 Industry consultant Kevin Kelley described the target customer
as a “Volvo-driving professor who could be CEO of a Fortune 100 company if he could get over his
capitalist angst.”44 One article about the company described the customers as follows:
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These are people who wear sunscreen, even over their tattoos; who travel on frequent-flier
miles and with the Lonely Planet guide rather than a Frommer’s. People who play guitar and
pay their taxes. Who roller-blade or bike to work on the days they’re not driving the minivan.
Who dress their kids in tie-dye but have really good car seats. Such folks might have
unfortunate thoughts about their fellow Americans while waiting in the sun for a parking
space, but they would never, ever yell at them out the window.45
Trader Joe’s enjoyed a cult-like following. Many customers launched online efforts to persuade
Trader Joe’s to open a store in their region. They created Facebook fan pages, wrote cookbooks
featuring meals prepared with the firm’s products, and waited in line for hours before a new store
grand opening. Founder Coulombe joked, “My children say that the Albrechts own the business, but
I own the cult.”46 One customer, Cherie Twohy, explained her passion for the company:
I’ve always been a Trader Joe’s groupie. I grew up in Southern California, as did TJ’s. . . . As
I became more interested in food and cooking, I found myself cruising the aisles of different TJ
stores, as they expanded, first in California, and then across the country. When I got ready to
open my own cooking school, Chez Cherie, I decided to see how much interest there might be
in classes focused on cooking with Trader Joe’s products. They’ve been so popular and are a
ton of fun to teach. In 2009 I was contacted by a publisher interested in doing a Trader Joe’s
cookbook. Since I’d been doing the classes for years, it seemed like a natural next step. The first
book came out in November 2009 and so far has sold over 70,000 copies!47
Several years earlier, CEO Dan Bane wrote a letter to employees describing why he felt Trader
Joe’s customers had become so loyal to the company. He explained, “Our people are warm and
friendly. It’s fun and an adventure. They find unexpected products. They experience cheap thrills.
Our people are helpful and knowledgeable. They know that we have tested each product to ensure
quality and satisfaction. They trust us.”48
Marketing Trader Joe’s marketed primarily through its Fearless Flyer as well as occasional
radio ads, and never ran television ads. The company produced the flyer and wrote the radio spots
itself rather than hiring an advertising agency. Employees rather than professional actors starred in
the commercials. In addition, one or more employees in each store served as the resident artists who
produced quirky hand-written signage. Trader Joe’s specifically chose not to employ a public
relations agency. Bane explained, “They are a waste of money. If you give your customers great
products at great prices, why do you need one?”49 Many customers had learned about Trader Joe’s
through word of mouth.
Unlike many grocers, the company did not have a loyalty-card program. Trader Joe’s also did not
offer or accept coupons.50 The Fearless Flyer provided information about various products, but it did
not advertise weekly sales. If customers were not satisfied with a product that they purchased, they
could return it with no questions asked. The firm explained its pricing philosophy in the frequently
asked question section of its website.
[Q:] Do you have weekly specials or sales on your products? [A:] “Sale” is a four-letter
word to us. We have low prices, every day. No coupons, no membership cards, no discounts.
You won’t find any glitzy promotions or couponing wars at our stores. If it makes you feel any
better, think of it as all our items are on sale, day in and day out. 51
If customers searched social media platforms for information about Trader Joe’s, they would not
find any official company Facebook pages or Twitter accounts. Trader Joe’s had not created any such
material. However, they would find a great deal of content generated by fans of the company.
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Hundreds of fan pages existed on Facebook: the “traderjoesfan” Facebook page had accumulated
over 550,000 “likes” as of July 2013.52 Customers also routinely created pages to try to persuade the
company to open a location in their towns. Such pages often attracted more than 5,000 followers in a
matter of weeks. One fan’s Twitter account—@traderjoeslist—described the “yummy, healthy Trader
Joe’s items” on her shopping list. She had more than 39,000 followers. 53 Customers uploaded videos
to YouTube as well. More than 880,000 people had viewed one fan’s “If I Made a Trader Joe’s
Commercial” video.54
Some experts bemoaned the absence of a company-led social media strategy. Nicole Spector of
Direct Marketing News wrote, “But no matter how ‘awesome’ and ‘amazing’ Trader Joe’s influence
on its fan base is, marketing experts concur that not having an authoritative voice in social media is a
weakness.”55 She gave the company a zero in the social media category on her marketing scorecard.
Sarah Mayer and Jennifer Ashley of Infiniti Marketing Solutions commented, “We think they are
missing a great opportunity to spread the loyalty and the customer experience outside of their store.
Their customers are talking about them in Twitter, on Facebook and beyond, so why not get involved
in that conversation?”56
People
Trader Joe’s continued to adhere to Coulombe’s strategy of paying staff more than they
might expect at rival grocers. New part-time hires typically earned $12 per hour. Full-time employees
earned approximately $50,000 per year. Store captains grossed more than $100,000 per year. Trader
Joe’s also contributed 15.4% of employees’ pay to retirement accounts. The company even offered
some health care benefits to part-time employees. According to Businessweek, the health care policy
made the store “a haven for artists, musicians, and other creative types who wouldn’t normally seek
supermarket jobs.”57
Trader Joe’s tended to receive many applicants for each job opening. When the company opened
its first store in Kansas City, it stopped taking applications after receiving 1,000 inquiries. The
company eventually hired 50 people from that applicant pool. When hiring, Trader Joe’s sought
extroverted individuals who could empathize with customers. Mark Gardiner, a former employee,
described the type of people with whom he had worked:
Trader Joe’s also extracts a ton of value from one of America’s least-utilized natural
resources: the pool of artsy, creative, college-educated young people who graduate without the
hard skills that would allow them to get technical jobs. As it turns out, kids who graduated
from their college theater program and (surprise!) couldn’t get a job acting; kids who got their
bachelor’s degree in history and then realized (oops!) there aren’t too many job openings for
historians . . . lots of those kids make great customer-service employees. . . . These kids
especially show their value in an environment where they’re empowered to do whatever it
takes to make sure customers are happy, and they’re given some creative leeway. Many of
them come to work at Trader Joe’s and feel really appreciated and (bonus!) that coming to
work is almost an extension of their social life, because they’re surrounded by people like
themselves.58
When new employees (“crewmembers” in Trader Joe’s lingo) came onboard, they received 10
days of training. Gardiner described the training he received before the grand opening of the firm’s
Kansas City store:
We had spent ten days of indoctrination before the Grand Opening. . . . I use the word
indoctrination to describe those first ten days, because the actual training was minimal.
Admittedly, most of the day-to-day work on the floor of a grocery store is menial. But I was
still struck by the ratio of time spent discussing values, compared to time spent discussing
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process. . . . What we did do, for hours, was listen to the Hawaiian shirts talk about Trader
Joe’s company values and the ways Trader Joe’s was different from other stores.59
Trader Joe’s did not trumpet its mission statement during these training sessions, as some
companies did. However, it emphasized the organization’s seven core values: integrity; we are a
product-driven company; at Trader Joe’s we create WOW customer experience every day; no
bureaucracy; we are a national chain of neighborhood grocery stores; KAIZEN!; the store is our
brand.60
Trader Joe’s wanted its employees to become familiar with the company’s products and therefore
encouraged them to try various items throughout the store. Each store received an expense account
that provided the funds for employees to sample new foods. Further, employees received a 10%
discount on their purchases. Of course, the company also provided many sampling opportunities for
its customers. If one walked through a Trader Joe’s on a weekend, one might find a handful of
different sampling stations.
Trader Joe’s expected its employees to be generalists, not specialists. To that end, crewmembers
learned how to do every job in the store. And the company promoted from within whenever possible.
While employees did specialize at times (e.g., the resident artists who made the signage), they tended
to rotate roles not only from day to day, but hour by hour. In fact, managers typically did not allow
crewmembers to work at the checkout stations for more than two hours at a time. And each hour a
different crewmember played the role of “helmsman,” greeting customers as they entered the store.61
Another unique feature of Trader Joe’s was that it discouraged its managers from making
announcements to crewmembers over the intercom system. Instead, the company implemented a bell
system to communicate key messages. The firm’s website explained the Trader Joe’s version of Morse
code: “One bell lets our Crew know when to open another register. Two bells mean there are
additional questions that need to be answered at the checkout. Three bells call over a manager-type
person.”62
Although many retailers restocked their shelves almost completely at night, when no customers
roamed the aisles, Trader Joe’s did not adhere to that common industry practice. One could find
crewmembers replenishing shelves even during peak shopping periods. However, managers stressed
that helping customers should always take priority over stocking shelves. If customers needed help
finding an item, crewmembers walked with them to the product’s location rather than just directing
them to a particular aisle.
While restocking shelves, crewmembers sometimes realized that the store had run out of certain
items, and managers gave them latitude to make adjustments on those occasions. Gardiner explained
that “crewmembers are told to fill empty spots with products they do have.”63 In fact, product
displays shifted constantly so as to keep the shelves looking full. Gardiner commented, “That means
stocking shelves, which could seem like a mind-numbingly tedious job (and it is one) is also a task
that involves making a constant series of adjustments.”64 Store managers, too, did not have to adhere
strictly to a “planogram” developed by the corporate office. They could adapt how and where
products were displayed based on their understanding of the local clientele.
Some observers marveled at how happy the crewmembers always seemed. Writer Carmel Lobello
wrote, “So what’s the deal? Is there booze in the water cooler in the break room? Are they all having
sex? Or are they really just that jazzed about selling $2 jars of chicken satay peanut sauce?”65 She
interviewed a long-time employee who told her, “When you hire friendly ‘people-people’ and then
when you take good care of them with really good benefits and a really good hourly wage it’s a self9
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Trader Joe’s
fulfilling prophecy.” He also explained that crewmembers often chose to “hang out together after
work.”66
At times, crewmembers also marveled at how friendly customers often were with one another.
Gardiner described one interaction his wife had with another customer at his store: “My wife was
shopping in what we call the HABA aisle (. . . ‘health and beauty aids’) when a total stranger started a
long conversation about the oatmeal soap. That’s just not the kind of thing that happens in regular
grocery stores. Where do people comfortably initiate conversations with strangers?”67
Looking Ahead
In 2013 Trader Joe’s continued to expand across the nation, but more rapidly than in the past,
although still at a measured pace relative to most retailers. Based on surveys of employees, Forbes and
Glassdoor.com ranked Trader Joe’s on their 2013 list of the “Top 50 Companies to Work For” in the
U.S. Many experts continued to marvel at the firm’s success.68
A feature article in Fortune heaped glowing praise on the company, although it did offer a few
words of caution. Writer Beth Kowitt questioned whether the company might lose its “charm” and
“quirky cool” as it expanded. One former employee explained, “In the early days we never tried to be
the neighborhood store.”69 In other words, he believed the local-neighborhood feel of those early
southern California stores was more authentic. Kowitt cited other ex-crewmembers who worried
about growing bureaucracy at the company as it implemented new processes and procedures. Mark
Gardiner expressed some concern as well. He described how recent changes had led to increased
competition among employees seeking advancement. 70
Despite those concerns, customers around the country continued to clamor for a new store near
them. Julie Merrill created a Facebook page to persuade Trader Joe’s to come to Utah, and she
attracted nearly 4,000 fans to her page. In June 2012, she heard the news that Trader Joe’s was coming
to her state. Merrill described her reaction to the local ABC affiliate: “I was psyched. . . oh my gosh!” 71
Deb Sussman waited in line for hours on November 30, 2012, when the Salt Lake City store finally
opened. She told reporters, “I have written over 50 letters to get them to come here.”72 Many thought
that Merrill or Sussman would be the first customers to enter when the Salt Lake City location
opened its doors for the first time, but that was not the case. David Stinson walked in first when the
store’s captain, Rory Violette, cut a giant lei at the entrance and welcomed customers into the store at
8:00 a.m. Stinson had camped out overnight to be first in line, having arrived at 4:00 p.m the previous
afternoon.73
10
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Trader Joe’s
Exhibit 1
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Top 12 Supermarkets in the United States (ranked by revenue)
Rank
Companya
1
2
3
4
5
6
7
8
9
10
11
12
Wal-Mart
Kroger
Safeway
Supervalu
Ahold USA
Publix
Delhaize America
H-E-B Grocery
Lone Star (Winn-Dixie)
Meijer
Whole Foods
Trader Joe’s
Source:
Grocery Salesb
(billions)
Square Feet of
Selling Area (millions)
$118.7
61.1
35.5
28.2
26.2
22.8
18.6
13.0
10.4
9.2
8.8
7.6
195.5
104.0
53.6
48.9
31.9
38.6
45.4
15.0
24.6
12.5
7.0
3.7
Progressive Grocer, “The Super 50,” May 2012, http://www.progressivegrocer.com/inprint/article/id2735/
artimages/PG/PG052012_table38.pdf, accessed September 2013.
a The list excluded warehouse clubs such as Costco, BJ’s, and Sam’s Club.
b The sales data included grocery merchandise only. The author (Progressive Grocer) omitted sales for other
merchandise sold in these stores, including apparel, electronics, appliances, etc. Therefore, the sales figures here did
not match published revenue reports by these companies.
11
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714-419
Trader Joe’s
Exhibit 2
Comparative 2011 Financial Performance of Selected Retailers (in $000s)
Whole Foods
Kroger
Safeway
Supervalu
Revenue
Cost of Goods Sold
Gross Profit
SG&A and Other Expenses
Operating Income
Net Income
$
$
$
$
$
$
10,107,787
6,571,238
3,536,549
2,988,929
547,620
342,612
$
$
$
$
$
$
90,374,000
71,494,000
18,880,000
17,602,000
1,278,000
602,000
$
$
$
$
$
$
43,630,200
31,836,500
11,793,700
10,659,100
1,134,600
516,700
$
$
$
$
$
$
36,100,000
28,081,000
8,019,000
8,538,000
(519,000)
(1,040,000)
Total Assets
Total Liabilities
Total Equity
$
$
$
4,292,075
1,300,770
2,991,305
$
$
$
23,476,000
19,510,000
3,966,000
$
$
$
15,073,600
11,384,500
3,689,100
$
$
$
12,053,000
12,032,000
21,000
Source:
Annual Reports of each firm.
12
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Trader Joe’s
714-419
Exhibit 3 Trader Joe’s Store Locations (as of July 2013): Existing Stores and
Future Openings Announced by the Company
State
California
Illinois
New York
Washington
Massachusetts
Arizona
Virginia
Oregon
New Jersey
Texas
Pennsylvania
North Carolina
Maryland
Minnesota
Georgia
Connecticut
Michigan
Nevada
Ohio
Source:
# of Stores
172
20
19
19
18
14
13
12
11
11
9
9
8
8
7
7
6
6
6
State
Missouri
Florida
Kentucky
New Mexico
South Carolina
Wisconsin
Colorado
Indiana
Nebraska
New Hampshire
Tennesee
Delaware
District of Columbia
Iowa
Kansas
Maine
Rhode Island
Utah
Louisiana
# of Stores
5
4
3
3
3
3
2
2
2
2
2
1
1
1
1
1
1
1
1
Adapted from “Where in the Dickens Can You Find a Trader Joe’s,” http://www.trader
joes.com/pdf/locations/all-llocations.pdf, accessed July 22, 2013.
13
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Trader Joe’s
Endnotes
1 Brad Tuttle, “How Two German-Owned Sister Supermarket Brands Became Hot Trendsetters in the U.S.,“
Time, July 29, 2013, http://business.time.com/2013/07/29/how-two-german-owned-sister-supermarket-brandsbecame-hot-trendsetters-in-the-u-s/, accessed July 2012.
2 “Wegmans, Trader Joe’s, Publix Top Consumer Reports Supermarket Survey: New tips to save big and
avoid costly in-store mistakes,” Consumer Affairs, April 6, 2009, http://www.consumeraffairs.com/news04/
2009/04/cr_supers.html, accessed July 20, 2012.
3 “Most Innovative Companies 2011,” Fast Company, http://www.fastcompany.com/most-innovativecompanies/2011/, accessed July 20, 2012.
4
Thad Moore, “Trader Joe’s draw traffic, hubbub over weekend,” The Daily Gamecock, March 25, 2013,
http://www.dailygamecock.com/article/2013/03/trader-joes-draws-traffic-hubbub-over-weekend,
accessed
July 23, 2013.
5
Beverly Fortune, “Lexington celebrates grand opening of Trader Joe’s,” Lexington Herald-Leader, June 29,
2012, http://www.kentucky.com/2012/06/29/2242518/trader-joes-in-lexington-opens.htm, accessed July 20,
2012.
6 Danika Kirka, “Tesco will pull out of US, sell Fresh & Easy,” USA Today, April 17, 2013, http://www.usa
today.com/story/money/business/2013/04/17/tesco-exits-usa/2090801/, accessed July 22, 2013.
7 Anne D’Innocenzio, “Wal-Mart Sees Early Success in Wal-Mart Express,” Businessweek, May 23, 2012,
http://www.businessweek.com/ap/2012-05/D9UUNAU80.htm, accessed July 20, 2012.
8
Karen Talley, “Walmart says its smaller stores make inroads,” Wall Street Journal, March 5, 2013,
http://online.wsj.com/article/SB10001424127887323494504578342421549936916.html, accessed July 22, 2013.
9 Sarah Perez, “Amazon Bets On Web Groceries, Expands AmazonFresh To L.A.,” TechCrunch, June 10, 2013,
http://techcrunch.com/2013/06/10/amazon-bets-on-web-groceries-expands-amazonfresh-to-l-a/, accessed July
25, 2013.
10 Patt Morrison, “Everybody’s got a Trader Joe’s story, and the original one belongs to the original Joe,
Joe Coulombe,” Los Angeles Times, May 7, 2011, http://articles.latimes.com/2011/may/07/opinion/la-oemorrison-joe-coulombe-043011, accessed July 16, 2012.
11
Trader Joe’s, “Timeline,” http://www.traderjoes.com/about/timeline.asp, accessed July 16, 2012.
12
Morrison, “Everybody’s got a Trader Joe’s story.”
13
Morrison, “Everybody’s got a Trader Joe’s story.”
14
Morrison, “Everybody’s got a Trader Joe’s story.”
15
ALDI, “Company Overview,” http://aldi.us/us/html/company/17536_ENU_HTML.htm?WT.z_src=
main, accessed July 23, 2013.
16 Walter Loeb, “Aldi’s Trader Joe’s is a Winner,” Forbes. May 17, 2012, http://www.forbes.com/
sites/walterloeb/2012/05/17/aldis-trader-joes-is-a-winner/, accessed July 17, 2012.
17 Juergen Baetz, “Theo Albrecht, one of Germany’s richest men, dies,” USA Today, July 28, 2010,
http://www.usatoday.com/money/world/2010-07-28-theo-albrecht_N.htm, accessed July 20, 2012.
18
Trader Joe’s, “Timeline.”
19
Trader Joe’s, “Timeline.”
14
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Trader Joe’s
714-419
20 Denis M. McSweeney, Walter J. Marshall, “The Prominence of Colleges and Universities in the Boston
Metropolitan Area,” Regional Report, U.S. Bureau of Labor Statistics, (Summary 09-01, February 2009),
http://www.bls.gov/opub/regional_reports/200902_colleges_boston.pdf , accessed December 2013.
21
Trader Joe’s, “Timeline.”
22
Trader Joe’s, “Timeline.”
23 Meg Major, Debra Chanil, and Nielsen TDLinx, “The Super 50 – Introduction / Methodology,” Progressive
Grocer, May 2012, http://www.progressivegrocer.com/inprint/article/id2735/the-super-50introductionmethodology/, accessed July 18, 2012.
24
Annie Gasparro and Timothy Martin, “What’s Wrong with America’s Supermarkets?” Wall Street Journal,
July 12, 2012, http://online.wsj.com/article/SB1000142405270230437380457752291224486 6078.html, accessed
July 23, 2012.
25
Whole Foods 2012 Annual Report.
26
Dollar General 2012 Annual Report.
27
Gasparro and Martin, “What’s Wrong with America’s Supermarkets?”
28
Wal-Mart 2012 Annual Report.
29
Gasparro and Martin, “What’s Wrong with America’s Supermarkets?”
30
Gasparro and Martin, “What’s Wrong with America’s Supermarkets?”
31
Trader Joe’s, “Find a Trader Joe’s,” http://www.traderjoes.com/stores/index.asp, accessed July 16, 2012.
32
PG Staff Editors and Debra Chanil, “The Super 50,” Progressive Grocer, May 5, 2013, http://www.
progressivegrocer.com/inprint/article/id5809/the-super-50/, accessed July 23, 2013.
33 Beth Kowitt, “Inside the Secret World of Trader Joe’s,” Fortune, August 23, 2010, http://money.cnn.com/
2010/08/20/news/companies/inside_trader_joes_full_version.fortune/index.htm, accessed July 16, 2012.
34 Dave Gardetta, “Enchanted Aisles,” Los Angeles Magazine. September 1, 2011, http://www.lamag.com/
features/Story.aspx?id=1515075, accessed July 20, 2012.
35
Queequeg, “The 5 Worst Trader Joe’s parking Lots in LA,” Blogging Los Angeles (blog), August 9, 2010
(9:19am), http://blogging.la/2010/08/19/the-5-worst-trader-joe%E2%80%99s-parking-lots-in-la/, accessed July
21, 2012.
36
Christopher Palmeri, “Trader Joe’s Recipe for Success,” Businessweek, February 20, 2008, http://www.
businessweek.com/stories/2008-02-20/trader-joes-recipe-for-success, accessed July 23, 2012.
37
Kowitt, “Inside the Secret World of Trader Joe’s.”
38
Mark Gardiner, Build a Brand Like Trader Joe’s (Seattle: Amazon Digital Services, 2012).
39
Gardiner, Build a Brand Like Trader Joe’s.
40
Morrison, “Everybody’s got a Trader Joe’s story.”
41
Kowitt, “Inside the Secret World of Trader Joe’s.”
42
Gardiner, Build a Brand Like Trader Joe’s.
43
Associated Press, “Trader Joe’s Targets ‘Educated’ Buyer,” Seattle Post-Intelligencer, August 29, 2003.
44
Kowitt, “Inside the Secret World of Trader Joe’s.”
15
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Trader Joe’s
45 Mary McNamara, “In the aisles of Trader Joe’s, a culture all its own,” Los Angeles Times, July 8, 2003,
http://articles.latimes.com/2003/jul/08/entertainment/et-mcnamara8, accessed July 23, 2012.
46
Beth Kowitt, “Meet the original Joe,” Fortune, August 23, 2010, http://features.blogs.fortune.cnn.com/
2010/08/23/meet-the-original-joe/, accessed July 17, 2012.
47
Cherie Twohy, “Guest Author: Cheri Twohy and the I Love Trader Joe’s Cookbook,” June 15, 2011, post on
blog “Living Vicuriously: The Zen of Unsure Things,” http://pasadenadailyphoto.blogspot.com/2011/06/
guest-author-cherie-twohy-and-i-love.html, accessed July 23, 2012.
48
Gardiner, Build a Brand Like Trader Joe’s.
49
Gardiner, Build a Brand Like Trader Joe’s.
50
Palmeri, “Trader Joe’s Recipe for Success.”
51
Trader Joe’s, “Trader Joe’s FAQs,” http://www.traderjoes.com/about/faq.asp, accessed July 23, 2013.
52 Trader Joe’s Fan, “Trader Joe’s Fan is on Facebook. To connect with Trader Joes Fan, . . .” Facebook online
fan community for Trader Joe’s stores and corporation, http://www.facebook.com/pages/Trader-JoesFan/15934023652, accessed July 23, 2013.
53 Trader Joe’s List, “Trader Joe’s items plus more listed daily. Fan Based!” Twitter Account devoted to
Trader Joe’s, https://twitter.com/traderjoeslist, accessed July 23, 2013.
54
Carlsfinefilms, “If I Made a Commercial for Trader Joe’s,” YouTube, January 27, 2009, http://www.you
tube.com/watch?v=OdB7GDZY3Pk, accessed July 23, 2013.
55 Nicole Spector, “Giant specialty supermarket chains attract similar consumers on different marketing
levels,” Direct Marketing News, July 1, 2012, http://www.dmnews.com/giant-specialty-supermarket-chainsattract-similar-consumers-on-different-marketing-levels/article/247400/, accessed July 24, 2012.
56 Sarah Mayer and Jennifer Ashley, “Trader Joe’s Lacks a Social Media Presence, Really!” Infiniti Marketing
Solutions, http://www.infinitimarketingsolutions.com/trader-joes-lacks-a-social-media-presence-really/, accessed
July 24, 2012.
57
Palmeri, “Trader Joe’s Recipe for Success.”
58
Gardiner, Build a Brand Like Trader Joe’s.
59
Gardiner, Build a Brand Like Trader Joe’s.
60
Gardiner, Build a Brand Like Trader Joe’s.
61
Gardiner, Build a Brand Like Trader Joe’s.
62
Trader Joe’s, “Trader Joe’s FAQs,” http://www.traderjoes.com/about/general-faq.asp, accessed July 24,
2012.
63
Gardiner, Build a Brand Like Trader Joe’s.
64
Gardiner, Build a Brand Like Trader Joe’s.
65
Carmel Lobello, “Why is everyone at Trader Joe’s so happy?” deathandtaxes, February 9, 2012,
http://www.deathandtaxesmag.com/178372/why-is-everyone-at-trader-joes-so-happy/, accessed July 20, 2012.
66
Lobello, “Why is everyone at Trader Joe’s so happy?”
67
Gardiner, Build a Brand Like Trader Joe’s.
16
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Trader Joe’s
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68 Jacquelyn Smith, “The Best Companies to Work For in 2013,” Forbes, December 12, 2012. http://www.
forbes.com/sites/jacquelynsmith/2012/12/12/the-best-companies-to-work-for-in-2013/, accessed July 22, 2013.
69
Kowitt, “Inside the Secret World of Trader Joe’s.”
70
Kowitt, “Inside the Secret World of Trader Joe’s.”
71
Chris Vancour, “The woman behind Utah’s Trader Joe’s Facebook page,” ABC4 News UTAH.com, June 6,
2012, http://www.abc4.com/content/news/top_stories/story/The-woman-behind-Utahs-Trader-Joes-Facebookpage/gDyOd99jvU66qJcSF71syQ.cspx?rss=20, accessed July 21, 2012.
72
Emily Clark, “Trader Joe’s opens doors in Salt Lake City,” ABC4 News UTAH.com, November 30, 2012,
http://www.abc4.com/content/news/top_stories/story/Trader-Joes-opens-doors-in-Salt-Lake-City/d8Uf8thq
uUGMJ71qlYT3_w.cspx , accessed July 23, 2013.
73
Haley Bissegger, “Sale Lake Trader Joe’s opens doors to Utah,” The Digital Universe, December 3, 2012,
http://universe.byu.edu/2012/12/03/salt-lake-trader-joes-opens-doors-to-utah/, accessed July 23, 2013.
17
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9-798-062
REV: FEBRUARY 25, 2006
PANKAJ GHEMAWAT
JAN W. RIVKIN
Creating Competitive Advantage
Some companies generate far greater profits than others. The pharmaceutical maker ScheringPlough produced an economic profit of more than $10 billion during the period 1984-2002. That is,
the accounting profit it generated exceeded its cost of equity capital by that amount. Over the same
period, U.S. Steel produced an economic loss of nearly $500 million; its cost of capital exceeded its
accounting profit by a wide margin. Such large differences in economic performance are
commonplace. Understanding their roots is crucial for strategists.
1
Differences in industry structure shed some light on such differences in performance. To a
certain extent, Schering-Plough has generated more economic profit than U.S. Steel because the
pharmaceutical industry is structurally more attractive than the steel industry. Rivalry in the
pharmaceutical market is muted by factors such as patent protection, product differentiation, and
expanding demand; in contrast, rivalry in the steel industry is fierce—fueled by excess capacity,
limited differences across products, and slow growth. Many pharmaceutical users hesitate to switch
among products or brands, while steel customers are usually willing to switch among producers to
get a better price. Many pharmaceuticals are made from commodities with little labor input, while
unions exercise such power in the steel industry that labor costs often account for a quarter of total
revenue. Such contrasts in industry-level competitive forces are one reason that the profit levels of
firms in different industries differ. Figure 1 shows, for each of many industries, the spread between
the industry’s return on equity and its cost of equity (the vertical axis) and the average equity in the
industry (the horizontal axis) for the period 1984-2002. Reflecting differences in industry-level
competitive forces, the pharmaceutical industry has been among the greatest generators of economic
profit, while the steel industry as a whole has produced losses. The typical pharmaceutical maker is
2
far more profitable than the typical steel producer.
Schering-Plough, however, is not a “typical pharmaceutical maker,” nor is U.S. Steel a “typical
steel producer.” As Figures 2a and 2b illustrate, industry averages can mask large differences in
economic profit within industries. Schering-Plough was far more effective at producing economic
profits than were many drug makers during the 1984-2002 period, while U.S. Steel performed far
worse than many other steel producers. Indeed, recent research indicates that intra-industry
differences in profitability like those shown in Figures 2a and 2b may be larger than differences
3
across industries such as those in Figure 1. Industry-level effects appear to account for 10-20% of the
variation in business profitability while stable within-industry effects account for 30-45%. (Most of
the remainder can be assigned to effects that fluctuate from year to year.)
________________________________________________________________________________________________________________
Professors Pankaj Ghemawat and Jan W. Rivkin prepared this note as the basis for class discussion. It is based in part on earlier notes by Pankaj
Ghemawat, Tarun Khanna, and Anita McGahan.
Copyright © 1998 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical,
photocopying, recording, or otherwise—without the permission of Harvard Business School.
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798-062
Creating Competitive Advantage
Economic Profits of U.S. Industry Groups, 1984-2002
Figure 1
Avg. Spread
(1984-2002)
Toiletry & Cosmetic
40%
Tobacco
30%
Soft Drinks
Pharmaceutical
Med Supplies
20%
Computer Software
Publishing
Financial Services
Petro-Integergrated
Aerospace/
Defense
Bank
10%
Retail Store
Railroad
Computers & Peripherals
Auto Parts
Building Materials
Insurance Property & Casualty
Auto & Truck
For El/Ent.
For Telecom
0%
Tele Service
Semiconduct
Air Transport
Textile
(10%)
Steel
(20%)
0
200
400
600
800
1,000
1,200
Power
Paper & For.
1,400
Entertain
1,600
1,800
2,000
Avg. Equity ($B) (1984-2002)
Source: Compustat, Value Line, Marakon Associates analysis
Figure 2a
Economic Profits in the Pharmaceutical Industry, 1984-2002
Mylan Laboratories
Watson Pharmaceuticals Inc
Forest Laboratories -Cl A
Pharmaceutical Prod Dev Inc
Covance Inc
Albany Molecular Resh Inc
Avg. Spread
(1984-2002)
40%
King Pharmaceuticals Inc
Schering-Plough
Merck & Co
Novo-Nordisk A/S -ADR
Novartis AG - ADR
Barr Laboratories Inc
Lilly (Eli) & Co
Bristol Myers Squibb
Pfizer Inc
Idec Pharmaceuticals Corp
Perrigo Co
Ivax Corp
Andrx Corp
Wyeth
20%
0%
Medicis Pharmaceut Cp -Cl A
Genzyme Corp
Parexel International Corp
Aventis Sa -ADR
(20%)
(40%)
(60%)
(80%)
0
5
10
15
20
25
Icn Pharmaceuticals Inc
Quintiles Transnational Corp
Chiron Corp
Protein Design Labs Inc
Sicor Inc
Gilead Sciences Inc
Enzon Pharmaceuticals Inc
Abgenix Inc
Cephalon Inc
Neurocrine Biosciences Inc
Tularik Inc
Medimmune Inc
Medarex Inc
Celgene Corp
30
35
40
Nektar Therapeutics
45
50
Avg. Equity ($B) (1984-2002)
Source: Compustat, Value Line, Marakon Associates analysis
2
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Creating Competitive Advantage
Figure 2b
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Economic Profits in the Steel Industry, 1984-2002
Avg. Spread
(1984-2002)
Worthington Industries
Gibraltar Steel Corp
6%
Steel Technologies
4%
Commercial Metals
Nucor Corp
2%
0%
(2%)
Quanex Corp
(4%)
Carpenter Technology
Dofasco Inc
Cleveland-Cliffs Inc
(6%)
United States Steel Corp
(8%)
AK Steel Holding Corp
(10%)
Ampco-Pittsburgh Corp
(12%)
Ryerson Tull Inc
(14%)
0
1
2
3
4
5
6
7
8
Avg. Equity ($B) (1984-2002)
Source: Compustat, Value Line, Marakon Associates analysis
In light of this, strategists need a systematic way to understand and analyze within-industry
differences in performance. Toward that end, this note uses the notion of competitive advantage. A
firm is said to have a competitive advantage over its rivals if it has driven a wide wedge between the
willingness to pay it generates among buyers and the costs it incurs—indeed, a wider wedge than its
4
competitors have achieved. A firm with a competitive advantage is positioned to earn superior
profits within its industry. In examining the logic of how firms create competitive advantage, this
note emphasizes two themes. First, to create an advantage, a firm must configure itself to do
something unique and valuable. The firm must ensure that, were it to disappear, someone in its
network of suppliers, customers, and complementors would miss it and no one could replace it
5
perfectly. The first section of the note uses the concept of “added value” to make this point more
precisely. Second, competitive advantage usually comes from the full range of a firm’s activities—
from production to finance, from marketing to logistics—acting in harmony. The essence of creating
advantage is finding an integrated set of choices that distinguishes a firm from its rivals. The second
section of the note shows how managers can analyze the full range of activities to understand the
sources of competitive advantage.
As a preface to the main discussion, it is important to address a few possible misconceptions.
Creating vs. sustaining competitive advantage. The note separates the challenge of creating
competitive advantage at a point in time from the problem of sustaining advantage over time. In
reality, the two issues are married: the choices that establish a firm’s advantage also influence
whether the advantage can be sustained. For instance, in launching its personal financial software
“Quicken,” Intuit chose to offer customers outstanding post-sale assistance over the telephone.
Customers valued the help from trained operators, and customer service became a tool for creating
competitive advantage. Moreover, customer service helped Intuit sustain its advantage over rivals
such as Microsoft. Competitors found it hard to match Intuit’s service operations and its reputation
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Creating Competitive Advantage
for excellent support. In addition, Intuit used information from its service operations to generate a
6
stream of ideas for improving its product.
Despite the connections between creating and sustaining advantage, we find it important to
discuss the two processes separately. Each is so complicated that it would be unwieldy to deal with
both at once.
Links to industry analysis. Within-industry differences in performance are often larger than
differences across industries, but it would be wrong to conclude that industry analysis is
unimportant. Industry analysis is crucial to creating competitive advantage for several reasons.
First, companies that generate competitive advantages typically do so by devising strategies that
neutralize the unattractive features of their industries and exploit the attractive features.
Second, industry conditions appear to have a large influence on whether competitive advantages
7
are even possible. In some industries (e.g., computer leasing), conditions “strait-jacket” firms and
leave them little room to establish a superior wedge between willingness to pay and costs. In other
industries (e.g., prepackaged software), conditions permit the most effective firms to enjoy large
advantages over the least.
Finally, market leaders often face a tension between managing industry structure and pursuing an
advantage within that structure. When deciding whether to build a new aluminum smelter, for
instance, Alcoa must consider the impact of the new capacity on industry supply-demand conditions,
not just its effect on Alcoa’s competitive advantage. This is true not only because Alcoa is a large
player in the business, but also because Alcoa is closely tracked by its rivals.
Analysis and creativity. This note takes an analytical approach to competitive advantage. In
actuality, many of the greatest advantages come not from analysis, but from entrepreneurial insight
and trial-and-error. The cold, hard analysis described here is not intended to deny the importance of
insight and trial-and-error. Rather, it aims to guide entrepreneurial creativity and to set a battery of
tests for new business ideas.
The Logic of Value Creation and Distribution
The first and foremost test in this battery concerns “added value,” a concept developed by Adam
8
Brandenburger, Barry Nalebuff, and Harborne Stuart. To introduce the concept, we use the example
9
of the portal crane business of Harnischfeger Industries. We then link added value to competitive
advantage.
Harnischfeger, based in Milwaukee, Wisconsin, manufactured equipment for industrial
customers. Its material handling equipment division served a range of customers, including forest
products companies such as International Paper. In the late 1970s, Harnischfeger began to offer these
customers a new product: portal cranes. Portal cranes were designed to lift entire tree-length logs off
of railcars and trucks and to hoist them around woodyards. The cranes were a significant
improvement over the giant forklifts that they replaced.
In fact, it was possible to calculate the customer benefits reasonably precisely. Each crane
replaced a fleet of forklifts which cost roughly $1.0 million. A crane was also less expensive to
operate than a forklift fleet; it required less labor, fuel, and maintenance, for instance. Altogether
over its lifespan, each crane generated a net present value of $6.5 million of savings in operating
costs. It cost Harnischfeger only $2.5 million to produce and install each crane. Thus a large gap
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existed between the customer benefits associated with a crane ($1.0 million + $6.5 million) and
Harnischfeger’s costs ($2.5 million). Despite this gap, Harnischfeger was making little profit on its
sales of portal cranes by the late 1980s. What happened?
Willingness to Pay and Supplier Opportunity Cost
A customer’s willingness to pay for a product or service is the maximum amount of money that a
customer would be willing to part with in order to obtain the product or service. In the
Harnischfeger example, a customer considering the purchase of a portal crane would be willing to
pay as much as $7.5 million for the crane. If it cost more than that, the customer would be better off
buying the forklifts for $1 million and paying the extra operating costs of $6.5 million.
The concept of supplier opportunity cost is precisely symmetrical to willingness to pay. It is the
smallest amount that a supplier will accept for the services and resources required to produce a good
or service. We call this an “opportunity cost” because it is dictated by the best opportunities that the
suppliers have to sell their services and resources elsewhere. In the example, the actual cost that
Harnischfeger incurred to deliver a portal crane was $2.5 million. We don’t know what the lowest
amount the suppliers would have accepted actually was, but we will speculate that it was not far
below $2.5 million, say $2.0 million.
Imagine that Harnischfeger is bargaining with International Paper, one of the largest paper
manufacturers, over the price of a portal crane. For now, suppose that Harnischfeger is the only
company that can provide a portal crane and International Paper is the sole customer. The price that
emerges from the bargaining may fall anywhere between $2.5 million, Harnischfeger’s cost, and $7.5
million, International Paper’s willingness to pay. (See Figure 3.) Our theory says nothing about
where the price will fall within this range. If Harnischfeger is a particularly tough bargainer, then the
price will tend toward $7.5 million. If International Paper is the shrewder negotiator, the price will
edge toward $2.5 million.
Figure 3: Division of Value
Supplier
opportunity
cost
Cost
Price
$2.0
mm
$2.5
mm
?
Supplier
share
Harnischfeger share
Willingness
to pay
$7.5
mm
International Paper share
Source: Brandenburger and Stuart, “Value-Based Business Strategy,” 1996
The total value created by a transaction is the difference between the customer’s willingness to pay
and the supplier’s opportunity cost. In the example, a sale of a crane to International Paper creates
value of $5.5 million: an item worth $7.5 million to the customer is created from supplied resources
that had a value of only $2.0 million in their next-best use. The value captured by Harnischfeger is
the difference between the negotiated price and $2.5 million. International Paper captures value
equal to $7.5 million minus the price. And suppliers capture $0.5 million (Figure 3).
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Added Value
A firm’s added value plays a large role in determining how much value it actually captures. The
added value of a firm is the maximal value created by all participants in a transaction minus the
maximal value that could be created without the firm. In essence, it is the value that would be lost to
the world if the firm disappeared. Consider the situation with Harnischfeger as the sole provider of
cranes and International Paper as the only customer. If Harnischfeger opts out of the transaction, the
entire $5.5 million of value goes un-created. Similarly, if International Paper refuses to participate,
$5.5 million of value is no longer generated. Both Harnischfeger and International Paper have an
added value of $5.5 million.
Now consider what happens in the late 1980s when Kranco, a management-buyout firm headed
by former Harnischfeger executives, enters the market for portal cranes. Assume that Kranco
produces an identical product, with costs of $2.5 million and supplier opportunity costs of $2.0
million, and it generates the very same willingness to pay of $7.5 million. The added value of
Harnischfeger is now $0. If it participates in a deal with International Paper, the total value created is
$5.5 million. If it opts out, Kranco can fill its place, and total value of $5.5 million is still generated.
Under a condition known as unrestricted bargaining, the amount of value a firm can claim cannot
exceed its added value. To see why this is so, assume for a moment that a lucky firm does strike a
deal that allows it to capture more than its added value. Then the value left over for the remaining
participants is less than the value that those others could generate by arranging a deal amongst
themselves. The remaining participants could break off and form a separate pact that improves their
collective lot. Any deal which grants a firm more than its added value is fragile because of such
separate pacts. Once Kranco enters, it is not surprising that Harnischfeger captures little value and is
barely profitable. After all, it has little or no added value. (See the top half of Figure 4.)
Figure 4: Added Value with Harnischfeger and Kranco Providing Cranes
Supplier opportunity cost of
Harnischfeger crane = $2.0 mm
Willingness to pay for
Harnischfeger crane = $7.5 mm
Harnischfeger
added value =
$0.0 mm
Total value created = $5.5 mm
Total value created = $5.5 mm
Supplier opportunity cost
of Kranco crane = 2.0 mm
Willingness to pay for
Kranco crane = 7.5 mm
Supplier opportunity cost of
Harnischfeger crane = $3.0 mm
Willingness to pay for
Harnischfeger crane = $9.0 mm
Total value created = $6.0 mm
Total value created = $5.5 mm
Supplier opportunity cost
of Kranco crane = 2.0 mm
Harnischfeger
added value =
$0.5 mm
Willingness to pay for
Kranco crane = 7.5 mm
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Suppose now that Harnischfeger discovers a way to add some new services to its core product.
(See the bottom half of Figure 4.) The services boost the willingness to pay of International Paper to
$9.0 million, but, because the services entail additional labor, they raise supplier opportunity costs to
$3.0 million. The total value created with Harnischfeger participating is now $9.0 million - $3.0
million = $6.0 million. The total value if Harnischfeger opts out and Kranco provides the crane is $7.5
million - $2.0 million = $5.5 million. The new service boosts Harnischfeger’s added value from $0 to
$0.5 million, essentially because it raises willingness to pay by more than it increases supplier
opportunity costs. By widening the gap between willingness to pay and supplier opportunity cost,
Harnischfeger increases the amount of value than it can potentially claim.
The Link to Competitive Advantage
The larger is a firm’s added value, the greater is its potential for profit. The logic laid out so far
suggests that a firm can boost its added value by widening the wedge it achieves between customer
willingness to pay and supplier opportunity cost beyond what rivals attain. We say that a firm with
a wider wedge has a competitive advantage in its industry. A firm with a competitive advantage has
added value and therefore the potential for profit. The notion of added value highlights the fact that
competitive advantage derives fundamentally from scarcity. A firm establishes added value by
making sure that it is unique in some valuable way—that the network of suppliers, customers, and
complementors within which it operates is more productive with it than without it and that it is not
readily replaced.
There are two basic ways a firm can establish an advantage. First, the firm can raise customers’
willingness to pay for its products without incurring a commensurate increase in supplier
opportunity cost. Second, the firm can devise a way to reduce supplier opportunity cost without
sacrificing commensurate willingness to pay. Either establishes the wider wedge that defines
competitive advantage.
Costs vs. supplier opportunity costs. So far, we have tried to treat buyers, with their willingness
to pay, and suppliers, with their opportunity costs, symmetrically. Just as willingness to pay captures
the most that buyers will pay for a product, opportunity cost is the least that suppliers will accept for
the resources used to make a product. The symmetry is useful: it reminds us that competitive
advantage can come from better management of supplier relations, not just from a focus on
downstream customers. Recent efforts to streamline supply chains reflect the importance of driving
down supplier opportunity costs.
In practice, however, managers often examine actual costs, not opportunity costs, because data on
actual costs are concrete and available. In the remainder of this note, we focus on the analysis of
actual costs. We assume, in essence, that supplier opportunity costs and actual costs track one
another closely. A firm’s quest for competitive advantage then becomes a search for ways to widen
the wedge between actual costs and willingness to pay.
Activity Analysis of Cost and Willingness to Pay
10
The Tension Between Cost and Willingness to Pay
Widening the wedge is difficult because, often, a firm must incur higher costs in order to deliver a
product or service for which customers are willing to pay more. Almost all customers would be
willing to pay more for a Toyota automobile than for a Hyundai, but the costs of manufacturing a
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Toyota are significantly higher than the costs of making a Hyundai. Toyota’s higher profit margins
derive from the fact that the difference in willingness to pay is greater than the incremental costs
associated with its product. As noted above, a firm can achieve a competitive advantage by devising
a way to (1) raise willingness to pay a great deal with only slight increases in costs or (2) reap large
cost savings with only slight decreases in customer willingness to pay. We call the first a
11
differentiation strategy and the second a low-cost strategy (Figure 5 ).
Figure 5: Types of Competitive Advantage
$
Industry
average
competitor
Successful
differentiated
competitor
Successful
low-cost
competitor
Competitor with
dual advantage
Willingness to pay
Supplier opportunity cost
(The term “differentiated” is often misused. When we say that a firm has differentiated itself, we
mean that it has boosted the willingness of customers to pay for its output—that it can command a
price premium. We do not mean simply that the company is different from its competitors. Hyundai
is certainly different from Toyota, but it is not differentiated with respect to Toyota. Similarly, a
common error is to say that a company has differentiated itself by charging a lower price than its
rivals. A firm’s choice of price does not usually affect how much customers are intrinsically willing
12
to pay for a good. )
The tension between cost and willingness to pay is not absolute: firms can discover ways to
produce superior products at lower cost. In the 1970s and 1980s, for instance, Japanese
manufacturers in a number of industries found that by reducing defect rates, they could make higherquality products at lower cost. More recently, Dell has developed a build-to-order model for
personal computers that reduces the costs of components, inventories, and obsolescence while also
boosting willingness to pay among knowledgeable computer buyers who value the speedy
customization that the model permits. Such examples of dual competitive advantage are eye-catching
13
and well worth understanding.
Strategy scholars debate, however, how common dual advantages are. Some have argued that
dual advantages are rare and are typically based on operational differences across firms that are
14
easily copied. Others contend that breaking the trade-offs between cost and willingness to pay—
replacing trade-offs with “trade-ons”—is a fundamental way to transform competition in an
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15
industry. Regardless, it is clear that there is a rich variety of ways to resolve the tension between
cost and willingness to pay favorably. Some examples illustrate the possibilities:
!
Accenture is regarded as a leader in information-technology consulting because of its deep
experience, reinforced by its research and development, its Knowledge Xchange portal, its
stringent hiring and training practices, its close relationships with CEOs as well as CIOs of
global corporations, and its successful attempts to build its brand. Some of the activities that
Accenture undertakes to differentiate itself are clearly costly: R&D and training, for instance,
swallow up 5% of revenues, even though they have been cut in recent years. On the other
hand, Accenture often faces no competing bids when it pitches consulting work and is able to
keep its revenues per consultant high, especially by maintaining a high utilization rate
16
(reportedly 78% in 2003, versus roughly 65% for the industry as a whole). This more than
compensates for the extra costs it incurs: Accenture has historically earned returns
significantly higher than most other large IT services companies.
!
Southwest Airlines has configured itself to focus on budget customers particularly well. It
standardizes its fleet around fuel-efficient Boeing 737s, concentrates on short-haul point-topoint routes between midsize cities and secondary airports, offers very low ticket prices and
no-frills service (no assigned seats, food service, baggage transfer or connections with other
airlines), emphasizes quick turnaround times, and manages to keep its planes in the air onethird longer each day than the average airline. Its stripped-down offering may generate
slightly less willingness to pay than the offering of a full-service airline, but it incurs far lower
costs than a full-service rival. As a result, Southwest is the only U.S. airline to have been
consistently profitable during the last 30 years, has grown at an annual rate of 20–30% over
the last five years, and maintains the lowest debt levels among the major carriers.
!
Cirque du Soleil is an innovative firm that combines elements of circus and theater. In
designing its performances, Cirque excluded many of the high-cost components of traditional
circuses—animals, star performers, and three ring shows—and focused on what it considered
to be the three elements responsible for the lasting allure of the circus: the clowns, the tent,
and the acrobatic acts. By refining the clowns’ acts, glamorizing the tent, and incorporating
elements from the world of theater—themes and storylines, for example—Cirque de Soleil
17
created a new category of entertainment with which it is synonymous. In essence, the firm
stripped out certain costly elements of the traditional circus and added costs in other areas for
which a segment of customers is willing to pay a great deal. In 2003, more than 7 million
people paid a total of $650 million to see its live performances, and the value of this privately18
held firm was estimated at $1.2 billion.
Activity Analysis
How can one identify opportunities to raise willingness to pay by more than costs or to drive
down costs without sacrificing too much willingness to pay? Sheer entrepreneurial insight certainly
plays a large role in spotting such opportunities. A Michael Dell sees that customers are becoming
comfortable with computer technology, realizes that retail sales channels add more costs than
benefits for many customers, and acts on his insight to start a direct-to-the-customer computer
19
business. Or a Liz Claiborne perceives huge pent-up demand for a collection of medium- to high20
end work clothes for female professionals. Dumb luck also plays a role. Engineers searching for a
coating material for missiles in the 1950s discovered the lubricant WD-40, whose sales continued to
generate a return on equity between 40% and 50% four decades later.
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We believe, however, that smart luck beats dumb luck and analysis can hone insight. To analyze
competitive advantage, strategists typically break a firm down into discrete activities or processes
and then examine how each contributes to the firm’s relative cost position or comparative willingness
21
to pay. The activities undertaken to design, produce, sell, deliver, and service goods are what
ultimately incur costs and generate customer willingness to pay. Differences across firms in
activities—differences in what firms actually do day-to-day—produce disparities in cost and
willingness to pay and hence dictate competitive advantage. By analyzing a firm activity by activity,
managers can (1) understand why the firm does or does not have a competitive advantage, (2) spot
opportunities to increase a firm’s competitive advantage, and (3) foresee future shifts in competitive
advantage.
An analysis of activities usually proceeds in four steps. First, managers of a firm catalog the firm’s
activities. Second, the managers examine the costs associated with each activity, and they use
differences in activities to understand how and why their costs differ from those of competitors.
Third, they analyze how each activity generates customer willingness to pay, and they use differences
in activities to examine how and why customers are willing to pay more or less for the goods or
services of rivals. Finally, the managers consider changes in the firm’s activities. The objective is to
identify changes that will widen the wedge between costs and willingness to pay. In the following
subsections, we discuss these steps in order.
Step 1: Catalog Activities (The Value Chain)
In the remainder of this note, we employ an activity template, the value chain, that can guide
22
managers in breaking down the firm into activities. The value chain divides all activities into two
classes: primary activities that directly generate a good or service, and support activities that make
the primary activities possible. Primary activities are broken down further into inbound logistics,
operations, outbound logistics, marketing and sales, and after-sales service. Support activities
include procurement of inputs, development of technology and human resources, and general firm
infrastructure. Figure 6 shows the value chain of an Internet start-up that sells compact discs online
and ships them by mail to customers.
Once activities have been cataloged, they must be analyzed in terms of cost and willingness to pay
relative to the competition. To illustrate how this is done, we focus on a simple example: the snack cake
market in the western region of Canada.* Between 1990 and 1995, Betsy Baking grew its share of this
market from a meager 1% to nearly 20%. At the same time, Collins Kitchen, the maker of such longtime favorites as Dinklets and Angel Dogs, saw its dominant 45% share dwindle to 25%. An analysis
of relative costs and willingness to pay shows why Betsy Baking and Collins fared so differently.
Step 2: Use Activities to Analyze Relative Costs
Competitive cost analysis is the usual starting point for the strategic analysis of competitive
advantage. In pure commodity businesses such as wheat farming, customers refuse to pay a
premium for any company’s product. In such a setting, a low-cost position is the key to added value
and competitive advantage. But even in industries that are not pure commodities, differences in cost
often wield a large influence on differences in profitability.
* The authors thank Roger Martin of Monitor Company for this example. Identities of the companies and other items have
been altered substantially to protect proprietary information.
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Figure 6: Value Chain for an Internet Start-up
FIRM
INFRASTRUCTURE
HUMAN
RESOURCES
TECHNOLOGY
DEVELOPMENT
PROCUREMENT
Financing, legal support, accounting
Recruiting, training, incentive system, employee feedback
Inventory
system
Site software
Pick & pack
procedures
Site look &
feel
Customer
research
CDs
Computers
Telecom lines
Shipping
services
Media
Shipping
Inbound
shipment of
top titles
Server
operations
Picking and
shipment of
top titles from
warehouse
Pricing
Returned items
Promotions
Customer
feedback
Shipment of
other titles
from thirdparty
distributors
Product
information
and reviews
OUTBOUND
LOGISTICS
MARKETING
& SALES
Warehousing
INBOUND
LOGISTICS
Billing
Collections
OPERATIONS
Advertising
Return
procedures
Support
activities
Primary
activities
Affiliations
with other
websites
SERVICE
Cost analysis was one of the efforts that managers at Collins Kitchens undertook in the mid-1990s
as they struggled to understand why their financial performance was poor and their market share
plummeting. They cataloged the major elements of their value chain and calculated the costs
associated with each class of activities. As Figure 7 shows, although Collins sold the typical package
of snack cakes to retailers for 72¢, raw materials (ingredients and packaging material) accounted for
only 18¢ per unit. Operation of automated baking, filling, and packaging production lines, largely
depreciation, maintenance, and labor costs, amounted to 15¢. Outbound logistics—delivery of fresh
goods directly to convenience stores and supermarkets, and maintenance of shelf space—constituted
the largest portion of costs, 26¢. Marketing expenditures on advertising and promotions added
another 12¢. A mere penny remained as profits for Collins.
The managers then determined the set of cost drivers associated with each activity. Cost drivers
are the factors that make the cost of an activity rise or fall. For instance, the managers realized that
the cost of outbound logistics per snack cake fell rapidly as a firm increased its local market share;
total delivery costs depended largely on the number of stops that a truck driver had to make, and the
larger was a firm’s market share, the greater was the number of snack cakes a driver could deliver
per stop. Urban deliveries tended to be more expensive than suburban because city traffic slowed
down drivers. Outbound logistics costs also rose with product variety; a broad product line made it
difficult for drivers to restock shelves and remove out-of-date merchandise. Finally, the nature of the
product affected logistics costs: snack cakes with more preservatives could be delivered less
frequently. The managers developed numerical relationships between activity costs and drivers, for
outbound logistics activities and for the other activities in Figure 7.
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Figure 7: Collins' Cost Components
80
70
Cents per unit
60
50
40
30
20
Profit
Marketing: Promotions
Marketing: Advertising
Outbound logistics
Operations: Manufacturing
Operations: Packaging
Operations: Ingredients
10
0
Cost drivers are critical because they allow managers to estimate competitors’ cost positions. One
usually cannot observe a competitor’s costs directly, but one can often observe the drivers. One can
see, for instance, a competitor’s market share, the portion of its sales in urban areas, the breadth of its
product line, and the ingredients in its products. Using its own costs and the numerical relationships
to cost drivers, a management team can estimate a competitor’s cost position.
When Collins’ managers did this for Betsy Baking, they found the results sobering. Because Betsy
Baking used inexpensive raw material, purchased in bulk, and tapped national scale economies, its
operations costs totaled 21¢, in contrast to 33¢ for Collins. Betsy Baking packed its product with
preservatives so that deliveries could be made less frequently, kept its product line very simple, and
benefited from growing market share. Consequently, its logistics costs per unit were less than half of
Collins’. Also, Betsy Baking did not run promotions. Altogether, the managers estimated, a package
of Betsy Baking snack cakes cost only 34¢ to produce, deliver, and market. Comparisons with the
two other major competitors, Ontario Baking and Savory Pastries, were not so discouraging. Indeed,
Collins had a small cost advantage over each. (See Figure 8.)
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This specific example illustrates a number of general points about relative cost analysis:
!
When reviewing a relative cost analysis, it is important to focus on differences in individual
activities, not just differences in total cost. Ontario Baking and Savory Pastries, for instance,
had similar total costs per unit. The two firms had different cost structures, however, and as
we will discuss below, these differences reflected distinct competitive positions.
!
Good cost analyses typically focus on a subset of all of a firm’s activities. The cost analysis in
Figure 8, for example, did not cover all the activities in the snack cake value chain. Effective
cost analyses usually break out in greatest detail and pay the most attention to cost categories
that (1) pick up on significant differences across competitors or strategic options, (2)
correspond to technically separable activities, or (3) are large enough to influence the overall
cost position significantly.
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This document is authorized for use only by Malik Kayal in BADM Strategy Summer 2020 taught by DAVID HALLIDAY, George Washington University from May 2020 to Nov 2020.
For the exclusive use of M. Kayal, 2020.
Creating Competitive Advantage
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Figure 8: Relative Cost Analysis
90
80
Profit
Cents per unit
70
Marketing: Promotions
60
Marketing: Advertising
50
Outbound logistics
40
Operations: Manufacturing
Operations: Packaging
30
Operations: Ingredients
20
10
0
Collins Kitchen
Betsy Baking
Ontario Baking
Savory Pastries
!
Activities that account for a thicker slice of costs deserve deeper treatment in terms of cost
drivers. For instance, the snack cake managers assigned several cost drivers to outbound
logistics and explored these drivers in depth. They spent little time considering the drivers of
advertising costs. The analysis of any cost category should focus on the drivers that have the
biggest impact on it.
!
A particular driver should be modeled only if it is likely to vary across the competitors or the
strategic options that will be considered. In the snack cake example, manufacturing location
influenced wages rates and therefore operations costs. All of the rivals manufactured their
snack cakes in western Canada, however, and manufacturing elsewhere was not an option
because shipping was costly and goods had to be delivered quickly. Consequently,
manufacturing location was not considered as a cost driver.
!
Finally, since the analysis of relative costs inevitably involves a large number of assumptions,
sensitivity analysis is crucial. Sensitivity analysis identifies the assumptions that really matter
and therefore need to be honed. It also tells the analyst how confident he or she can be in the
results. Under any reasonable variation of the assumptions, Betsy Baking had a substantial
cost advantage over Collins.
A number of references discuss cost drivers in greater detail and suggest specific ways to model
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them numerically. The catalog of potential drivers is long. Many relate to the size of the firm:
economies of scale, economies of experience, economies of scope, capacity utilization, etc. Others
relate to differences in firm location, functional policies, timing (e.g., first-mover advantages),
institutional factors such as unionization, government regulations such as tariffs, and so forth.
Differences in the resources possessed by a firm may also drive differences in activity costs. A farm
with more productive soil, for instance, will incur lower fertilization costs.
A number of pitfalls commonly snare newcomers to cost analysis. Many companies, particularly
ones that produce large numbers of distinct products in a single facility, still have grossly inadequate
costing systems that must be cleaned up before they can be used as reference points for estimating
competitors’ costs. As courses on management accounting point out, conventional accounting
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This document is authorized for use only by Malik Kayal in BADM Strategy Summer 2020 taught by DAVID HALLIDAY, George Washington University from May 2020 to Nov 2020.
For the exclusive use of M. Kayal, 2020.
798-062
Creating Competitive Advantage
systems often overemphasize manufacturing costs and do a poor job of allocating overhead and other
indirect costs. As firms increasingly sell services and transact on the basis of knowledge, these
25
outdated systems make it harder and harder to analyze costs intelligently. Also problematic is a
tendency to compare costs as a percentage of sales rather than in absolute dollar terms. This
confounds cost and price differences. It is also common, but dangerous, to mix together recurring
costs and one-time investments. Some analysts confuse differences in firms’ costs with differences in
their product mixes. One can avoid this problem by comparing the cost positions of comparable
products; compare Ford’s four-cylinder, mid-sized family sedan to Toyota’s four-cylinder, mid-sized
family sedan, not some imaginary “average” Ford to some “average” Toyota. Finally, a focus on
costs should not crowd out consideration of customer willingness to pay—the topic of the next
section.
Step 3: Use Activities to Analyze Relative Willingness to Pay
The activities of a firm do not just generate costs. They also (one hopes) make customers willing
to pay for the firm’s product or service. Differences in activities account for differences in willingness
to pay and hence for competitive advantage and differences in profitability. In general, it appears
that differences in willingness to pay account for more of the variation in profitability observed
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among competitors than do disparities in cost levels.
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Virtually any activity in the value chain can affect customers’ willingness to pay for a product.
Most obviously, the product design and manufacturing activities that influence physical product
characteristics—quality, performance, features, aesthetics, durability—affect willingness to pay.
Consumers pay a premium for New Balance athletic shoes in part because the firm offers durable
shoes in hard-to-find sizes. In fact, by avoiding deals with superstar athletes and publicizing that its
shoes are “endorsed by no one,” New Balance actively emphasizes to consumers that they should
pay attention only to the physical characteristics of its shoes. More subtly, a firm can boost
willingness to pay through activities associated with sales or delivery—the ease of purchase, speed of
delivery, availability and terms of credit, convenience of the seller, quality of presal...
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