Panera Bread Company in 2015

timer Asked: Nov 15th, 2016

Question description

Read Case # 5 (in your textbook), "Panera Bread Company in 2015: What to Do to Rejuvenate the Company's Growth?" and perform the following analysis:

  1. What are the chief elements of Panera Bread's strategy?
  2. Perform a SWOT analysis for Panera Bread. Does the company has any core competencies or distinctive competencies?
  3. Perform financial/performance analysis of the company based on the data in the case for 2009-2014 period.
  4. What strategic issues or problems does Panera Bread management need to address? ? What are your recommendations to address those issues/problems to top management?

Chapters 4 and 5 of your text provide detailed discussion of topics/tools that you would need to know in order to complete this assignment. Also, Appendix on pages 228-229 is useful to address question #3.

case 5 Panera Bread Company in 2015—What to Do to Rejuvenate the Company’s Growth? ARTHUR A. THOMPSON  The University of Alabama In spring 2015, Panera Bread was widely regarded as the clear leader of the “fast-casual” segment of the restaurant industry. Fast-casual restaurants were viewed as being a cut above traditional quickservice restaurants such as McDonald’s because of better food quality, limited table service, and, in many instances, often wider and more upscale menu selections. On average, 7.8 million customers patronized Panera Bread restaurants each week, and Panera baked more specialty breads daily than any other bakery-café enterprise in North America. There were 1,880 company-owned and franchised bakery-cafés in operation in 45 states, the District of Columbia, and Ontario, Canada, under the Panera Bread, Saint Louis Bread Co., and Paradise Bakery & Café names. In 2014, the company had corporate revenues of $2.5 billion, systemwide store revenues of $4.5 billion, and average sales of almost $2.5 million per store location. The number of Panera Bread locations was up from 1,027 units in 36 states at the end of 2006 but well short of the ambitious target the company set in 2006 to have 2,000 outlets in operation by the end of 2010. While the Great Recession of 2008–2009 had forced management to scale back Panera’s expansion plans, the company decided to reinstitute its rapid growth strategy by opening a net of 76 new company-operated and franchised units in 2010, 88 new units in 2011, 111 new units in 2012, 125 units in 2013, and 114 units in 2014. Plans called for opening 105 to 115 new company-operated and franchised units in 2015. But despite the recent acceleration of store openings, the company’s 6.0 percent revenue growth in 2014 fell far short of the robust 19.9 percent compound average growth achieved during 2009-2013. Moreover, sales at bakery-cafés open at least one year rose only 1.1 percent in 2014, compared to 2.3 percent in 2013 and 6.5 percent in 2012. The growth slow-down, coupled with higher operating expenses, squeezed Panera’s profitability, resulting in a decline in net income from $196.2 million in 2013 to $179.3 million in 2014 and a drop in earnings per share from $6.85 in 2013 to $6.67 in 2014—the first such earnings decline since 2007. Top management in February 2015 indicated that it was expecting 2015 sales gains of between 2.0 and 3.5 percent at Panera bakery-cafés open at least one year. But despite the addition of more stores, management’s profit forecast for 2015 was uninspiring; diluted earnings per share in 2015 were projected to be anywhere from flat to down mid- to high-single digits, far below the company’s targeted long-term EPS growth rate of 15 to 20 percent annually. Company Background In 1981, Louis Kane and Ron Shaich founded a bakery-café enterprise named Au Bon Pain Co., Inc. Units were opened in malls, shopping centers, and airports along the east coast of the United States and internationally throughout the 1980s and 1990s; the company prospered and became the dominant operator within the bakery-café category. In 1993, Au Bon Pain Co. purchased Saint Louis Bread Company, a chain of 20 bakery-cafés located in the St. Louis area. Ron Shaich and a team of Au Bon Pain Copyright © 2015 by Arthur A. Thompson. All rights reserved. Case 5  Panera Bread Company in 2015—What to Do to Rejuvenate the Company’s Growth?   301 managers then spent considerable time in 1994 and 1995 traveling the country and studying the market for fast food and quick-service meals. They concluded that many patrons of fast-food chains such as McDonald’s, Wendy’s, Burger King, Subway, Taco Bell, Pizza Hut, and KFC could be attracted to a higher-quality quick dining experience. Top management at Au Bon Pain then instituted a comprehensive overhaul of the newly acquired Saint Louis Bread locations, altering the menu and the dining atmosphere. The vision was to create a specialty café anchored by an authentic, fresh dough, artisan bakery and upscale, quick-service menu selections. Between 1993 and 1997, average unit volumes at the revamped Saint Louis Bread units increased by 75 percent, and over 100 additional Saint Louis Bread units were opened. In 1997, the Saint Louis Bread bakery-cafés were renamed Panera Bread in all markets outside St. Louis. By 1998, it was clear the reconceived Panera Bread units had connected with consumers. Au Bon Pain management concluded the Panera Bread format had broad market appeal and could be rolled out nationwide. Ron Shaich believed Panera Bread had the potential to become one of the leading “fast-casual” restaurant chains in the nation. Shaich also believed that growing Panera Bread into a national chain required significantly more management attention and financial resources than the company could marshal if it continued to pursue expansion of both the Au Bon Pain and Panera Bread chains. He convinced the Au Bon Pain Board of Directors that the best course of action was for the company to go exclusively with the Panera Bread concept and divest the Au Bon Pain cafés. In August 1998, the company announced the sale of its Au Bon Pain bakery-café division for $73 million in cash to ABP Corp.; the transaction was completed in May 1999. With the sale of the Au Bon Pain division, the company changed its name to Panera Bread Company. The restructured company had 180 Saint Louis and Panera Bread bakery-cafés and a debt-free balance sheet. Between January 1999 and December 2006, close to 850 additional Panera Bread bakery-cafés were opened, some company-owned and some franchised. In February 2007, Panera purchased a 51 percent interest in Arizona-based Paradise Bakery & Café, which operated 70 company-owned and franchised units in 10 states (primarily in the west and southwest) and had sales close to $100 million. At the time, Paradise Bakery units had average weekly sales of about $40,000 and an average check size of $8 to $9. Panera purchased the remaining 49 percent ownership of Paradise Bakery in June 2009. In 2008, Panera expanded into Canada, opening two locations in Ontario; since then, 10 additional units in Canada had been opened. In May 2010, William W. Moreton, Panera’s Executive vice president and co-chief operating officer, was appointed president and chief executive officer and a member of the company’s board. Ron Shaich, who had served as Panera’s president and CEO since 1994 and as chairman or co-chairman of the board of directors since 1988, transitioned to the role of executive chairman of the board. In addition to the normal duties of board chairman, Shaich maintained an active strategic role, with a particular focus on how Panera Bread could continue to be the best competitive alternative in the market segments the company served. However, on March 15, 2012, the company announced that Ron Shaich and Bill Moreton would become coCEOs, effective immediately; Shaich’s formal title was changed to chairman of the board and co-CEO and Moreton’s title became president and co-CEO. In August 2013, Shaich and Moreton took on new titles because of family-related issues that required more of Bill Moreton’s time: Shaich became chairman of the board and CEO and Moreton was named executive vice chairman, with a role of helping oversee Panera’s business operations. In February 2015, Moreton also held the title of interim chief financial officer. Over the years, Panera Bread had received a number of honors and awards. In 2015, Fast Company  magazine named Panera Bread as the Most Innovative Company in Food. In 2011, 2012, and 2013, Harris Poll EquiTrend® Rankings named Panera Bread as Casual Dining Restaurant Brand of the Year.1 Zagat’s 2012 Fast Food Survey of 10,500 diners ranked Panera as fourth for Top Food, second for Top Décor, and fifth for Top Service among national chains with fewer than 5,000 locations.2 For nine of the past 12 years (2002-2013), customers 302  Part 2  Cases in Crafting and Executing Strategy had rated Panera Bread tops on overall satisfaction among large chain restaurants in Sandelman & Associates’ Quick-Track study “Awards of Excellence” surveys; in Sandelman’s 2012 Quick-Track study of more than 110,000 customers of quick-­ service restaurants, Panera ranked number one in the Attractive/Inviting restaurant category.3 A summary of Panera Bread’s recent financial performance is shown in Exhibit 1. Exhibit 2 provides selected operating statistics for Panera’s ­company-owned and franchised bakery-cafés. Panera Bread’s Concept and Strategy Panera Bread’s identity was rooted in its freshbaked, artisan breads made with a craftsman’s attention to quality and detail. The company’s breads and baked products were a major basis for differentiating Panera from its competitors. According to Panera management, “Bread is our passion, soul, and expertise, and serves as the platform that makes all of our other food special.” The featured menu offerings at Panera locations included breads and pastries baked in-house, breakfast items and smoothies, madeto-order sandwiches, signature soups and salads, and café beverages. Recognizing that diners chose a dining establishment based on individual food preferences and mood, Panera strived to be the first choice for diners craving fresh-baked goods, a sandwich, soup, a salad, or a beverage served in a warm, friendly, comfortable dining environment. Its target market was urban workers and suburban dwellers looking for a quick service meal or light snack and an aesthetically pleasing dining experience. Management’s long-term objective and strategic intent was to make Panera Bread a nationally recognized brand name and to be the dominant restaurant operator in upscale, quick-service dining. Top management believed that success depended on “being better than the guys across the street” and making the experience of dining at Panera so attractive that customers would be willing to pass by the outlets of other fast-casual restaurant competitors to dine at a nearby Panera Bread bakery-café.4 Panera management’s blueprint for attracting and retaining customers was called Concept Essence. Concept Essence underpinned Panera’s strategy and embraced several themes that, taken together, acted to differentiate Panera from its competitors: ∙ Offering an appealing selection of artisan breads, bagels, and pastry products that were handcrafted and baked daily at each café location ∙ Serving high-quality food at prices that represented a good value ∙ Developing a menu with sufficiently diverse offerings to enable Panera to draw customers from breakfast through the dinner hours each day ∙ Providing courteous, capable, and efficient customer service ∙ Designing bakery cafés that were aesthetically pleasing and inviting ∙ Offering patrons such a sufficiently satisfying dining experience that they were induced to return again and again Panera Bread’s menu, store design and ambience, and unit location strategies enabled it to compete successfully in multiple segments of the restaurant business: breakfast, AM “chill” (when customers visited to take a break from morning-hour activities), lunch, PM “chill” (when customers visited to take a break from afternoon activities), dinner, and take home, through both on-premise sales and off-premise catering. It competed with a wide assortment of specialty food, casual dining, and quick-service establishments operating nationally, regionally, and locally. Its close competitors varied according to the menu item, meal, and time of day. For example, breakfast and AM “chill” competitors included Starbucks and McDonald’s; close lunch and dinner competitors included such chains as Chili’s, Applebee’s, California Pizza Kitchen, Jason’s Deli, Cracker Barrel, Ruby Tuesday, T.G.I. Friday’s, Chipotle Mexican Grill, and Five Guys Burgers and Fries. In the bread and pastry segment, Panera competed with Corner Bakery Café, Atlanta Bread Company, Au Bon Pain, local bakeries, and supermarket bakeries. Case 5  Panera Bread Company in 2015—What to Do to Rejuvenate the Company’s Growth?   303 EXHIBIT 1 Selected Consolidated Financial Data for Panera Bread, 2009–2014 (in thousands, except for per-share amounts) Income Statement Data Revenues:  Bakery-café sales   Franchise royalties and fees   Fresh dough and other product sales to   franchisees   Total revenues Bakery-café expenses:   Food and paper products  Labor  Occupancy   Other operating expenses   Total bakery-café expenses Fresh dough and other product cost of sales to  franchisees Depreciation and amortization General and administrative expenses Pre-opening expenses   Total costs and expenses Operating profit Interest expense Other (income) expense, net Income taxes Less net income (loss) attributable to   noncontrolling interest Net income to shareholders Earnings per share  Basic  Diluted Weighted average shares outstanding  Basic  Diluted Balance Sheet Data Cash and cash equivalents Current assets Total assets Current liabilities Total liabilities Stockholders’ equity Cash Flow Data Net cash provided by operating activities Net cash used in investing activities Net cash (used in) provided by financing activities Net (decrease) increase in cash and cash  equivalents 2014 2013 2012 2011 2009 $2,230,370 123,686 $2,108,908 112,641 $1,879,280 102,076 $1,592,951 92,793 $1,153,255 78,367     175,139 2,529,195     163,453 2,385,002     148,701 2,130,057     136,288 1,822,032     121,872 1,353,494 669,860 685,576 159,794     314,879 1,830,109 625,622 625,457 148,816     295,539 1,695,434 552,580 559,446 130,793     256,029 1,498,848 470,398 484,014 115,290     216,237 1,285,939 337,599 370,595 95,996     155,396 959,586 152,267 124,109 138,060      8,707 2,253,252 275,943 1,824 (3,175) 98,001 142,160 106,523 123,335      7,794 2,075,246 309,756 1,053 (4,017) 116,551 131,006 90,939 117,932      8,462 1,847,187 282,870 1,082 (1,208) 109,548 116,267 79,899 113,083     6,585    1,601,773 220,259 822 (466) 83,951 100,229 67,162 83,169      2,451     1,212,597 140,897 700 273 53,073     --$179,293     --$196,169     --$173,448     --$ 135,952       801 $ 86,050 $6.67 6.64 $6.85 6.81 $5.94 5.89 $4.59 4.55 $2.81 2.78 26,881 26,999 28,629 28,794 29,217 29,455 29,601 29,903 30,667 30,979 $196,493 406,384 1,390,902 352,712 654,718 736,184 $125,245 302,716 1,180,862 303,325 177,645 699,892 $297,141 478,842 1,268,163 277,540 168,704 821,919 $ 222,640 353,119 1,027,322 238,334 372,246 655,076 $246,400 322,084 837,165 142,259 240,129 597,036 $ 335,079 (211,317) (52,514) $ 348,417 (188,307) (332,006) $ 289,456 (195,741) (19,214) $ 236,889 (152,194) (91,354) $ 214,904 (49,219) 6,005 71,248 (171,896) 74,501 (6,659) 171,690 Source: 2014 10-K report, pp. 41–43; 2013 10-K report, pp. 41–43; 2011 10-K Report, pp. 41–43; and 2010 10-K Report, pp. 29–30, 46–48. 304  Part 2  Cases in Crafting and Executing Strategy EXHIBIT 2 Selected Operating Statistics, Panera Bread Company, 2009–2014 Revenues at company-operated stores   (in millions) Revenues at franchised stores (in millions) Systemwide store revenues (in millions) Average annualized revenues per company-­   operated bakery-café (in millions) Average annualized revenues per franchised bakery-café (in millions) Average weekly sales, company-owned  cafés Average weekly sales, franchised cafés Comparable bakery-café sales percentage  increases* Company-owned outlets Franchised outlets System-wide Company-owned bakery-cafés open at  year-end Franchised bakery-cafés open at year-end Total bakery-cafés open 2014 2013 2012 2011 2010 2009 $2,230.4 $2,108.9 $1,879.3 $1,593.0 $1,321.2 $1,153.3 $2,282.0 $4,512.4 $2.502 $2,175.2 $4,284.1 $2.483 $1,981.7 $3,861.0 $2.435 $1,828.2 $3,421.2 $2.292 $1,802.1 $3,123.3 $2.179 $1,640.3 $2,793.6 $2.031 $2.455 $2.448 $2.419 $2.315 $2,266 $2.109 $48,114 $47,741 $46,836 $44,071 $41,899 $39,050 47,215 47,079 46,526 $44,527 $43,578 $40,566 1.4% 0.9% 1.1% 925       955 1,880 4.5% 3.9% 2.3% 867       910 1,777 6.5% 5.0% 5.7% 809       843 1,652 4.9% 3.4% 4.0% 740       801 1,541 7.5% 8.2% 7.9% 662       791 1,453 2.4% 2.0% 2.2% 585       795 1,380 *The percentages for comparable store sales are based on annual changes at stores with an open date prior to the first day of the prior fiscal year (meaning that a store had to be open for all 12 months of the year to be included in this statistic). Source: Company 10-K Reports for 2014, 2013, 2011, and 2010. Except for bread and pastry products, Panera’s strongest competitors were dining establishments in the so-called “fast-casual” restaurant category. Fastcasual restaurants filled the gap between fast-food outlets and casual, full table service restaurants. A fast-casual restaurant provided quick-service dining (much like fast-food enterprises) but was distinguished by enticing menus, higher food quality, and more inviting dining environments; typical meal costs per guest were in the $7–$12 range. Some fastcasual restaurants had full table service, some had partial table service (with orders being delivered to the table after ordering and paying at the counter), and some were self-service (like fast-food establishments, with orders being taken and delivered at the counter). Exhibit 3 provides information on prominent national and regional dining chains that competed against Panera Bread in some or many geographical locations. Panera Bread’s growth strategy was to capitalize on Panera’s market potential by opening both company-owned and franchised Panera Bread locations as fast as was prudent. So far, working closely with franchisees to open new locations had been a key component of the company’s efforts to broaden its market penetration. Panera Bread had organized its business around company-owned bakery-café operations, franchise operations, and fresh dough operations; the fresh bread unit supplied dough and other products to all Panera Bread stores, both ­company-owned and franchised. Panera Bread’s Product Offerings and Menu Panera Bread’s artisan signature breads were made from four ingredients: water, natural yeast, flour, and salt; no preservatives or chemicals were used. Carefully trained bakers shaped every step of the process, from mixing the ingredients, to kneading the dough, to placing the loaves on hot stone slabs to bake in a traditional European-style stone Case 5  Panera Bread Company in 2015—What to Do to Rejuvenate the Company’s Growth?   305 EXHIBIT 3 Representative Fast-Casual Restaurant Chains and Selected Full-Service Restaurant Chains in the United States, 2014 Company Number of Locations, 2013 Select 2013–2014 ­Financial Data Key Menu Categories Atlanta Bread Company ~100 company-owned and franchised bakery-cafés in 21 states Not available (privately held company) Applebee’s Neighborhood Grill and Bar* (a subsidiary of DineEquity) 2,017 franchised locations in 49 states, 2 U.S. territories, and 15 countries outside the U.S. 2014 average annual sales of about $2.5 million per U.S. location Au Bon Pain 300+ company-owned and franchised bakery-cafés in 26 states and 5+ foreign countries 300+ bakery-cafés in 26 states, the District of ­Columbia, and Canada Not available (privately held company) Fresh-baked breads, salads, sandwiches, soups, wood-fired pizza and pasta (select locations only), baked goods, desserts Beef, chicken, pork, seafood, and pasta entrees, plus appetizers, salads, sandwiches, a selection of under-500 calorie Weight Watchers–branded menu alternatives, desserts, alcoholic beverages (about 12 percent of total sales) Baked goods (with a focus on croissants and bagels), soups, salads, sandwiches and wraps, coffee drinks Fresh-baked New York–style bagels, breads, sandwiches, salads, soups, desserts, signature coffees Signature California-style hearth-baked pizzas, plus salads, pastas, soups, sandwiches, appetizers, desserts, beer, wine, coffees, teas, assorted beverages Chicken, beef, and seafood entrees, steaks, appetizers, salads, sandwiches, desserts, alcoholic beverages (14.1 percent of sales) Gourmet burritos and tacos, salads, beverages (including margaritas and beers) Bruegger’s Bagels Not available (privately held company) California Pizza Kitchen* (a subsidiary of Golden Gate Capital) 265 locations in 32 states and Average annual sales of 10 other countries about $3.2 million per location Chili’s Grill and Bar* (a subsidiary of Brinker International) 1,262 locations in 50 states and 307 locations in 31 foreign countries and territories 2014 average revenues of ~$2.9 million per location; 2014 average check size per customer of $14.31 Chipotle Mexican Grill 1,770+ units Corner Bakery Café (a subsidiary of Roark Capital Group) 185 locations in 20 states and District of Columbia (planning to have 250+ locations by year-end 2015) 2014 revenues of $4.1 billion; average unit sales of ~$2.5 million; average check size $10.17 Menu price range: $0.99 to $8.99 Cracker Barrel* 634 combination retail stores and restaurants in 42 states Specialty breads, hot breakfasts, signature sandwiches, grilled panini, pastas, seasonal soups and chili, made-to-order salads, sweets, coffees, teas Restaurant-only sales of Two menus (all-day breakfast $2.14 billion in 2014; averand lunch/dinner); named by age sales per restaurant Technomics in both 2013 and of $3.42 million; average 2015 as the full restaurant guest check of $9.75; category winner of its “Chain serves an average of ~1,000 Restaurant Consumers’ Choice customers per day per Award” location 306  Part 2  Cases in Crafting and Executing Strategy Company Number of Locations, 2013 Select 2013–2014 ­Financial Data Culver’s 500+ locations in 22 states Not available (a privately held company) Key Menu Categories Signature hamburgers served on buttered buns, fried battered cheese curds, value dinners (chicken, shrimp, cod with potato and slaw), salads, frozen custard, milkshakes, sundaes, fountain drinks Einstein Noah Restaurant ~850 company-owned, franAnnual sales revenues $434 Fresh-baked bagels, hot breakGroup (Einstein Bros. Bagels, chised, and licensed locations million; annual revenue per fast sandwiches, made-to-order Noah’s New York Bagels, Man- in 40 states company-owned unit of lunch sandwiches, creamed hattan Bagel) ~$850,000 cheeses and other spreads, salads, soups, gourmet coffees and teas Fazoli’s (a subsidiary of Sun 220+ locations in 26 states 2014 sales of ~$260 million Spaghetti and meatballs, fettucCapital Partners) cine Alfredo, lasagna, ravioli, submarines and panini sandwiches, pizza, entrée salads, garlic bread sticks, desserts Firehouse Subs 860+ locations in 38+ states Average unit sales of Hot and cold subs, salads, sides, (plans for 2,000 locations by $~800,000 drinks, catering; ranked #2 2020 in Sandelman and Associates Quick-Track® 2014 Awards of Excellence for Large QuickService Restaurant Chains (over 500 units) Five Guys Burgers and Fries ~1,500+ locations in 47 Not available (a privately Hamburgers (with choice of 15 states and 6 Canadian held company) toppings), hot dogs, fries, Cocaprovinces Cola, beverages Fuddruckers (a subsidiary ~180 company-owned and Not available Exotic hamburgers (the feature of Luby’s Inc.; 2014 sales of franchised locations in 34 menu item), chicken and fish $368.3 million) states, the District of Columsandwiches, French fries and bia, Puerto Rico, and Canada other sides, soups, salads, desserts Jason’s Deli 240+ locations in 28 states Not available (a privately Sandwiches, extensive salad held company) bar, soups, loaded potatoes, desserts, catering services, party trays, box lunches Moe’s Southwest Grill (a sub- 500+ locations in 37 states 2013 sales of $526 million; Burritos, quesadillas, fajitas, sidiary of Roark Capital Group) and the District of Columbia average annual sales per tacos, nachos, rice bowls restaurant of ~$1.1 million (chicken, pork, or tofu), salads with a choice of two homemade dressings, a kid’s menu, five side items (including queso and guacamole), two desserts (cookie or brownie), soft drinks, iced tea, bottled water, catering McAlister’s Deli (a subsidiary 341 locations in 24 states Not available (a privately Deli sandwiches, loaded baked of Roark Capital Group) held company) potatoes, soups, salads, and desserts, plus sandwich trays, lunch boxes, catering Noodles & Company 440+ urban and suburban 2014 sales of $404 million; Customizable Asian, Mediterlocations in 32 states and comparable store sales ranean, and American noodle/ District of Columbia growth of 0.2% in 2014; pasta entrees, soups, salads, average check size $8.00 sandwiches, alcoholic beverages Case 5  Panera Bread Company in 2015—What to Do to Rejuvenate the Company’s Growth?   307 Company Number of Locations, 2013 Qdoba Mexican Grill (a subsid- 638 company-owned and iary of Jack-in-the-Box, Inc.) franchised locations in 47 states, District of Columbia, and Canada Ruby Tuesday* 744 company-owned and franchised locations in 44 states, 13 foreign countries, and Guam Starbucks ~11,960 company-operated and licensed locations in the U.S. and 9,400+ international locations 930 locations in 60 foreign countries and territories T.G.I. Friday’s* (a subsidiary of Sentinel Capital Partners and TriArtisan Capital Partners) Select 2013–2014 ­Financial Data Key Menu Categories Average unit sales per location of $1,090,000 in 2014; comparable store sales growth of 6.0% in 2014 Signature burritos, tacos, taco salads, quesadillas, threecheese nachos, Mexican gumbo, tortilla soup, five signature salsas, breakfast selections at some locations Fiscal 2014 sales of $1.17 Appetizers, handcrafted burgbillion; average restaurant ers, 35-item salad bar, steaks, sales of $1.67 million; typifresh chicken, crab cakes, lobcal entrée price ranges of ster, salmon, tilapia, ribs, des$7.49 to $19.99 serts, nonalcoholic and alcoholic beverages, catering 2014 global revenues of Italian-style espresso beverages, $16.4 billion; sales of $1.29 teas, sodas, juices, assorted pasmillion per company-opertries and confections; some locaated location in the Americas tions offer sandwiches and salads Not available (a privately Appetizers, salads, soups, held company) burgers and other sandwiches, chicken, seafood, steaks, pasta, desserts, nonalcoholic and alcoholic beverages, party platters *Denotes a full-service restaurant. Source: Company web sites, accessed March 16, 2015. deck bakery oven. Breads, as well as bagels, muffins, cookies, and other pastries, were baked fresh throughout the day at each café location. Exhibit 4 shows Panera’s lineup of breads. The Panera Bread menu was designed to provide target customers with products built on the company’s bakery expertise, particularly its varieties of breads and bagels baked fresh throughout the day at each café location. The key menu groups were fresh baked goods, hot breakfast selections, bagels and cream cheese spreads, hot panini, made-to-order sandwiches and salads, soups, fruit smoothies, frozen drinks, beverages, and espresso bar selections. Exhibit 5 summarizes the menu offerings at Panera Bread locations as of March 2015. Menu offerings were regularly reviewed and revised to sustain the interest of regular customers, satisfy changing consumer preferences, and be responsive to various seasons of the year. Special soup offerings, for example, appeared seasonally. Product development was focused on providing food that customers would crave and trust to be tasty. New menu items were developed in test kitchens and then introduced in a limited number of the bakery-cafés to determine customer response and verify that preparation and operating procedures resulted in product consistency and high quality standards. If successful, they were then rolled out systemwide. New product introductions were integrated into periodic or seasonal menu rotations, referred to as “Celebrations.” Ten new menu items were introduced in 2010, 14 new or improved items appeared on the menu in 2011, 8 different selections (5 new ones and 3 that had been put back on the menu after being removed in prior periods) were featured on Panera’s 2012 menu, 20 new menu items appeared on the menu during the course of 5 celebrations held throughout 2013, and 22 new and reintroduced selections were featured during the 5 celebrations in 2014. Over the past 10 years, Panera had responded to growing consumer interest in healthier, more nutritious menu offerings. In 2004, whole grain breads were introduced, and in 2005, Panera switched to the use of natural antibiotic chicken in all of Panera’s chicken-related sandwiches and salads. Other 308  Part 2  Cases in Crafting and Executing Strategy EXHIBIT 4 Panera’s Line of Fresh-Baked Breads, March 2015 Artisan Breads Specialty Breads Country A crisp crust and nutty flavor. Available in loaf. Sourdough Panera’s signature sourdough bread with no fat, oil, sugar, or cholesterol. Available in loaf. Asiago Cheese Standard sourdough recipe with Asiago cheese baked in and sprinkled on top. Available in demi, loaf. Honey Wheat Sweet and hearty with honey and molasses. Available in loaf. French Slightly blistered crust, wine-like aroma. Available in baguette, miche. Ciabatta A moist, chewy crumb with a thin crust and light olive oil flavor. Available in loaf. Focaccia Italian flatbread baked with olive oil and topped with either asiago cheese or sea salt. Available in loaf. Rye With chopped rye kernels and caraway seeds. Available in loaf. Three Cheese Made with parmesan, romano, and asiago cheeses. Available in loaf. Three Seed Sesame, poppy, and fennel seeds. Available in demi. Whole Grain Moist and hearty, sweetened with honey. Available in loaf. Sesame Semolina Delicate, moist, and topped with sesame seeds. Available in loaf. All-Natural White Bread Soft and tender white sandwich bread. Available in loaf. Tomato Basil Sourdough bread made with tomatoes and basil, and sweet streusel topping. Available in XL loaf. Cinnamon Raisin Swirl Fresh dough made with flour, whole butter, and eggs, swirled with Vietnamese and Indonesian cinnamons, raisins, and brown sugar, topped with Panera’s cinnamon crunch topping. Available in loaf. Sprouted Whole Grain Roll Available as single or pack of 6. Soft Dinner Roll Available as single or pack of 6. Source:, accessed March 17, 2015. recent health-related changes included using organic and all-natural ingredients in selected items, using unbleached flours in its breads, adding a yogurt-­ granola-fruit parfait and reduced-fat spreads for bagels to the menu, introducing fruit smoothies, increasing the use of fresh ingredients (such as freshfrom-the-farm lettuces and tomatoes), and revising ingredients and preparation methods to yield zero grams of artificial trans fat per serving. All of the menu boards and printed menus at company-owned Panera bakery-cafés included the calories for each food item. Also, Panera’s website had a nutritional calculator showing detailed nutritional information for each individual menu item or combination of menu selections. Off-Premises Catering  In 2004–2005, Panera Bread introduced a catering program to extend its market reach into the workplace, schools, and parties and gatherings held in homes, and grow their breakfast-, lunch-, and dinner-hour sales without making capital investments in additional physical facilities. The first menu consisted of items appearing on the regular menu and was posted for viewing at the company’s website. A catering coordinator was available to help customers make menu selections, choose between assortments or boxed meals, determine appropriate order quantities, and arrange pick-up or delivery times. Orders came complete with plates, napkins, and utensils, all packaged and presented in convenient, ready-to-serve-from packaging. Case 5  Panera Bread Company in 2015—What to Do to Rejuvenate the Company’s Growth?   309 EXHIBIT 5 Panera Bread’s Menu Selections, March 2015 Bakery Artisan and specialty breads (17 varieties), bagels (11 varieties), scones (4 varieties), sweet rolls (3 varieties), muffins and "muffies" (6 varieties), artisan pastries (7 varieties), brownies, cookies (7 varieties) Bagels and cream cheese spreads (11 varieties of bagels, 8 varieties of spreads) Hot breakfast Breakfast sandwiches (10 varieties), baked egg soufflés (4 varieties) Strawberry Granola Parfait Steel-Cut Oatmeal Power Almond Quinoa Oatmeal Fruit smoothies (5 varieties) Fresh fruit cup Signature hot paninis Frontega Chicken, Chipotle Chicken, Smokehouse Turkey, Steak and White Cheddar Signature sandwiches Napa Almond, Chicken Salad, Asiago Steak, Italian Combo, Bacon Turkey Bravo Café sandwiches Smoked Ham and Swiss, Roasted Turkey and Avocado BLT, Tuna Salad, Mediterranean Veggie, Sierra Turkey, Fontina Grilled Cheese, Classic Grilled Cheese, Smoked Turkey Flatbread sandwiches Turkey Cranberry, Mediterranean Chicken, Southwestern Chicken, Tomato Mozzarella Signature pastas Chicken Sorrentina, Chicken Tortellini Alfredo, Mac & Cheese, Pesto Sacchettini, Tortellini Alfredo, Pasta Primavera Soups (5 selections varying daily, plus seasonal specialties) Options include: Broccoli Cheddar, Bistro French Onion, Baked Potato, Low-Fat All-Natural Chicken Noodle, Cream of Chicken and Wild Rice, New England Clam Chowder, Low-Fat Vegetarian Garden Vegetable with Pesto, Low-Fat Vegetarian Black Bean, Vegetarian Creamy Tomato, All-Natural Turkey Chili Café salads Caesar, Classic, Greek Signature salads Chicken Cobb, Chicken Cobb with Avocado, Chicken Caesar, Asian Sesame Chicken, Fuji Apple Chicken, Thai Chicken, BBQ Chicken, Mediterranean Shrimp Couscous, Greek with Shrimp, Classic with Chicken, Greek with Chicken, Power Chicken Hummus Bowl, Steak and Blue Cheese Broth bowls Soba Noodle with Chicken, Soba Noodle with Edamame, Lentil Quinoa with Chicken, Lentil Quinoa with Cage-Free Egg Panera Kids Grilled Cheese Sandwich, Peanut Butter and Jelly Sandwich, Smoked Ham Sandwich, Smoked Turkey Sandwich, Mac & Cheese, Buttered Ribbon Noodles, 10 varieties of regular and seasonal soups, 3 salads Beverages Coffee (hot or iced), hot teas, iced tea, iced green tea, Pepsi beverages, Dr. Pepper, bottled water, San Pellegrino, organic milk, chocolate milk, orange juice, organic apple juice, lemonade, fruit punch, Sierra Mist fountain soda Frozen drinks Frozen Caramel, Frozen Mocha Espresso Bar Espresso, cappuccino, Caffe Latte, Caffe Mocha, Vanilla Latte, Caramel Latte, Skinny Caffe Mocha, Chai Tea Latte (hot or iced), Signature Hot Chocolate Source: Menu posted at, accessed March 18, 2015. In 2010, Panera boosted the size of its catering sales staff and introduced sales training programs and other tools—factors that helped drive a 26 percent increase in catering sales in 2010. In 2011, Panera introduced an online catering system that catering customers could use to view the catering menu, place orders, specify whether the order was to be picked up or delivered to a specified location, and pay for purchases. The 65-item catering menu in 2015 included breakfast assortments, bagels and spreads, sandwiches and boxed lunches, salads, soups, pasta dishes, pastries and sweets, and a selection of beverages. In large geographic locations with multiple bakery-cafés, Panera operated catering-only “delivery hubs” to expedite deliveries of customer orders. Going forward, top executives at Panera believed that offpremise catering was an important revenue growth opportunity for both company-­ operated and franchised locations. 310  Part 2  Cases in Crafting and Executing Strategy The MyPanera Loyalty Program  In 2010, Panera initiated a loyalty program to reward customers who dined frequently at Panera Bread locations. The introduction of the MyPanera program was completed systemwide in November, and by the end of December, some 4.5 million customers had signed up and become registered card members. Members presented their MyPanera card when ordering. When the card was swiped, the specific items being purchased were automatically recorded to learn what items a member liked. As Panera got an idea of a member’s preferences over the course of several visits, a member’s card was “loaded” with such “surprises” as complimentary bakery-café items, exclusive previews and tastings, cooking and baking tips, invitations to special events, ideas for entertaining, or recipe books. On a member’s next visit, when an order was placed and the card swiped, order-taking personnel informed the member of the surprise award. Members could also go online at and see if a reward was waiting on their next visit. In March 2015, the company’s MyPanera program had over 19 million members, and in both 2013 and 2014, approximately 50 percent of the transactions at Panera Bread bakery-cafés were attached to a MyPanera loyalty card. Management believed that the loyalty program had two primary benefits. One was to entice members to dine at Panera more frequently and thereby deepen the bond between Panera Bread and its most loyal customers. The second was to provide Panera management with better marketing research data on the purchasing behavior of customers and enable Panera to refine its menu selections and market messages. The Panera 2.0 Marketing Initiative In 2012, Panera began testing a newly developed Panera 2.0 app that enabled digital ordering and payment by customers and that included capabilities store employees and managers could use to perform an assortment of internal operating activities. The app was adaptable to the differentiated needs of dine-in, to-go, and large-order delivery customers The tests in 14 bakery-cafés were such a huge success that Panera began rolling out the full Panera 2.0 experience to its entire network of company-operated and franchised bakery cafés in 2013, a process that management expected to complete in 2016. Introduction of the “Rapid Pickup” component of Panera 2.0, which featured mobile ordering and payment for customers picking up orders at a particular bakery-café, was completed systemwide in early 2015. Management expected the Panera 2.0 technology to enhance the guest experience, aid the introduction of marketing innovations, permit cost-efficient handling of a growing number of customer transactions volumes, and pave the way for greater operating efficiencies in its bakery-cafés. Panera’s Nonprofit Pay-What-You-Want ­Bakery-Café Locations In May 2010, Panera Bread converted one of its restaurants in a wealthy St. Louis suburb into a nonprofit pay-what-you-want Saint Louis Bread Cares bakery-café with the idea of helping to feed the needy and raising money for charitable work. A sign in the bakery-café said, “We encourage those with the means to leave the requested amount or more if you’re able. And we encourage those with a real need to take a discount.” The menu board listed “suggested funding levels,” not prices. Payments went into a donation box, with the cashiers providing change and handling credit card payments. The hope was that enough generous customers would donate money above and beyond the menu’s suggested funding levels to subsidize discounted meals for those who were experiencing economic hardship and needed help. The restaurant was operated by Panera’s charitable Panera Bread Foundation; all profits from the store were donated to community programs. After several months of operation, the Saint Louis Bread Cares store was judged to be successful enough that Ron Shaich, who headed the Panera Bread Foundation, opted to open two similar Panera Cares cafés—one in the Detroit suburb of Dearborn, Michigan, and one in Portland, Oregon. At one juncture, Panera statistics indicated that roughly 60 percent of store patrons left the suggested amount; 20 percent left more, and 20 percent less.5 Of course, there were occasional instances in which a patron tried to game the system. Ron Shaich cited the case of a college student who ordered more than $40 worth of food and charged only $3 to his father’s credit card; Shaich, who happened to be working in the store behind the Case 5  Panera Bread Company in 2015—What to Do to Rejuvenate the Company’s Growth?   311 counter, had to restrain himself, saying “I wanted to jump over the counter.”6 One person paid $500 for a meal, the largest single payment. Although in May 2011, Panera had intentions to open a new pay-whatyou-want store every three months or so, the company still had only three pay-what-you-want café locations as of April 2012, but two locations were added in the next nine months—one in Chicago and one in Boston. Panera expected to serve over 1 million people at the five pay-what-you-can locations in 2013.7 Statistics showed that in 2013, about 60 percent of store patrons left the suggested amount, 20 percent left more, and 20 percent less, often significantly less.8 In March 2013, Panera introduced a special “Meal of Shared Responsibility”—turkey chili in a bread bowl—at a suggested retail price of $5.89 (tax included) at 48 locations in the St. Louis area. The idea was that the needy could get a nutritious 850-calorie meal for whatever they could afford to pay, while those who pay above the company’s cost make up the difference.9 The program was supported by heavy media coverage at launch, extensive in-store signage, and employees explaining how the meal worked. For the first three weeks, customers on average paid above the retail value, but then payments dropped off to an average of around 75 percent of retail value. After six weeks, in-store signage was taken down to promote other meal options and the conversation about the “Meal of Shared Responsibility” faded into the background. Then in July 2013, after serving about 15,000 of the turkey chili meals, Panera canceled the program, chiefly because few needy people were participating—an outcome attributed largely to most Panera locations in the St. Louis area being located in middle-class and affluent neighborhoods. Management indicated it would rethink its approach to social responsibility and possibly retool the program. Later in 2014, the Chicago location of Panera Cares was closed, but the other four locations were still open in March 2015. Marketing In the company’s early years, marketing had played only a small role in Panera’s success. Brand awareness had been built on customers’ satisfaction with their dining experience at Panera and their tendency to share their positive experiences with friends and neighbors. From time to time, Panera had utilized focus groups to determine customer food and drink preferences and price points. In 2006, Panera’s marketing research indicated that about 85 percent of consumers who were aware that there was a Panera Bread bakery-café in their community or neighborhood had dined at Panera on at least one occasion; 57 percent of consumers who had “ever tried” dining at Panera Bread had been customers in the past 30 days.10 Panera’s research also showed that people who dined at Panera Bread very frequently or moderately frequently typically did so for only one part of the day, although 81 percent indicated “considerable willingness” to try dining at Panera Bread at other parts of the day. This data prompted management to pursue three marketing initiatives during 2006–2007. One aimed at raising the quality of awareness about Panera by continuing to feature the caliber and appeal of its breads and baked goods, by hammering home the theme “food you crave, food you can trust,” and by enhancing the appeal of its bakery-cafés as a neighborhood gathering place. A second initiative sought to raise awareness and boost customer trials of dining at Panera Bread at multiple meal times (breakfast, lunch, “chill out” times, and dinner). The third initiative was to increase perception of Panera Bread as a viable evening meal option by introducing a number of new entrée menu selections. Panera avoided hard-sell or “in your face” marketing approaches, preferring instead to employ a range of ways to softly drop the Panera Bread name into the midst of consumers as they moved through their lives and let them “gently collide” with the brand. The idea was to let consumers “discover” Panera Bread and then convert them into loyal repeat customers by providing a very satisfying dining experience when they tried Panera bakery-cafés for the first time or opted to try dining at Panera at a different part of the day, particularly during breakfast or dinner as opposed to the busier lunchtime hours. These initiatives were only partially successful, partly because of the difficult economic environment that emerged in 2008–2009 and partly because the new dinner entrées that were introduced did not prove popular 312  Part 2  Cases in Crafting and Executing Strategy enough to significantly boost dinner-hour traffic and were dropped from the menu; in 2011–2012, the only hot entrée on the menu was Mac & Cheese. But in 2013–2014, new entrees appeared in growing numbers during the five annual celebration periods. Panera management was committed to growing sales at existing and new unit locations, continuously improving the customer experience at its restaurants, and encouraging frequent customer visits via the new menu items featured during the periodic celebrations, increased enrollment of patrons in the MyPanera loyalty programs, and efforts to strengthen relationships with customers who, management believed, would then recommend dining at Panera to their friends and acquaintances. Panera hired a new chief marketing officer and a new vice president of marketing in 2010; both had considerable consumer marketing experience and were playing an important role in crafting the company’s long-term marketing strategy to increase awareness of the Panera brand, develop and promote appealing new menu selections, expand customer participation in the MyPanera loyalty program, and otherwise make dining at Panera bakery-cafés a pleasant and satisfying experience. To promote the Panera brand and menu offerings to target customer groups, Panera employed a mix of radio, billboards, social networking, the Internet, and periodic cable television advertising campaigns. In recent years, Panera had put considerable effort into (a) improving its advertising messages to better capture the points of difference and the soul of the Panera concept and (b) doing a better job of optimizing the media mix in each geographic market. Whereas it was the practice at many national restaurant chains to spend 3 to 5 percent of revenues on media advertising, Panera’s advertising expenses had typically been substantially lower, running as low as 0.6 percent of systemwide sales at companyowned and franchised bakery-cafés in 2008. But in the past five years, Panera had started upping its advertising effort to help spur sales growth. Advertising expenses totaled $33.2 million in 2011 (1.00 percent of systemwide bakery-café sales), $44.5 million in 2012 (1.15 percent of systemwide bakerycafé sales), $55.6 million in 2013 (1.30 percent of systemwide bakery-café sales), and $65.5 million in 2014 (1.45 percent of systemwide bakery-café sales). The increased advertising expenses in 2014 were to support Panera’s first-ever national television advertising campaign, an initiative that was financed by both Panera and its franchisees. Panera’s franchise agreements required franchisees to contribute a specified percentage of their net sales to advertising. In 2013, Panera’s franchiseoperated bakery-cafés were required to contribute 1.8 percent of their sales to a national advertising fund and to pay Panera a marketing administration fee equal to 0.4 percent of their sales; Panera contributed the same net sales percentages from companyowned bakery-cafés toward the national advertising fund and the marketing administration fee. Franchisees were also required in 2013 to spend amounts equal to 1.6 percent of their net sales on advertising in their local markets. Over the past eight years, Panera had raised the contribution of both companyowned and franchised bakery cafés to the national advertising fund—from 0.4 percent of net sales prior to 2006 to 0.7 percent beginning January 2006 to 1.2 percent beginning July 2010 to 1.6 percent starting April 2012. However, to help offset these increases, the amounts franchisees were expected to spend for local advertising had been reduced from 2.0 percent of net sales beginning July 2010 to 1.6 percent of net sales beginning April 2012. Under the terms of its franchise agreements, Panera had the right to increase national advertising fund contributions to a maximum of 2.6 percent of net sales. To support the new national advertising campaign beginning in 2014, Panera exercised its right to require franchisees to pay the maximum 2.6 percent of net sales to the company’s national advertising fund. However, the marketing administration fee of 0.4 percent of net sales remained unchanged and the required percentage franchisees had to spend on advertising in their respective local market areas was reduced from 1.6 percent to 0.8 percent beginning January 2014. Franchise Operations Opening additional franchised bakery-cafés was a core element of Panera Bread’s strategy and management’s initiatives to achieve the company’s revenue growth and earnings targets. Panera Bread did not grant single-unit franchises, so a prospective Case 5  Panera Bread Company in 2015—What to Do to Rejuvenate the Company’s Growth?   313 franchisee could not open just one bakery-café. Rather, Panera Bread’s franchising strategy was to enter into franchise agreements that required the franchise developer to open a number of units, typically 15 bakery-cafés in a period of six years. Franchisee candidates had to be well-capitalized, have a proven track record as excellent multi-unit restaurant operators, and agree to meet an aggressive development schedule. Applicants had to meet eight stringent criteria to gain consideration for a Panera Bread franchise: ∙ ∙ ∙ ∙ ∙ Experience as a multi-unit restaurant operator Recognition as a top restaurant operator Net worth of $7.5 million Liquid assets of $3 million Infrastructure and resources to meet Panera’s development schedule for the market area the franchisee was applying to develop ∙ Real estate experience in the market to be developed ∙ Total commitment to the development of the Panera Bread brand ∙ Cultural fit and a passion for fresh bread Exhibit 6 shows estimated costs of opening a new franchised Panera Bread bakery-café. The franchise agreement typically required the payment of a $5,000 development fee for each bakery-café contracted for in a franchisee’s “area development agreement,” a franchise fee of $30,000 per bakery-café (payable in a lump sum at least 30 days prior to the scheduled opening of a new bakery-café), and continuing royalties of 5 percent on gross sales at each franchised bakery-café. Franchise-operated bakerycafés followed the same standards for in-store operating standards, product quality, menu, site selection, and bakery-café construction as did company-owned bakery-cafés. Franchisees were required to purchase all of their dough products from sources approved by Panera Bread. Panera’s fresh dough facility system supplied fresh dough products to substantially all franchise-operated bakery-cafés. Panera did not finance franchisee construction or area development agreement payments, or hold an equity interest in any of the franchise-operated bakery-cafés. All area development agreements executed after March 2003 included a clause allowing Panera Bread the right to purchase all bakery-cafés opened by the franchisee at a defined purchase price at any time five years after the execution of the franchise agreement. In 2010, Panera purchased 37 bakery-cafés from the franchisee in the New Jersey market and sold 3 bakery-cafés in the Mobile, Alabama, market to an existing franchisee. In 2011, Panera completed the purchase of 25 bakery-cafés owned by its Milwaukee franchisee and 5 bakery-cafés owned by an Indiana franchisee; also in 2011, Panera sold 2 Paradise Bakery & Café units to a Texas franchisee and terminated the franchise agreements for 13 Paradise bakery-cafes that were subsequently rebranded by the former franchisee. In 2012, Panera acquired 16 bakery-cafés from a North Carolina franchisee, and in 2013, it acquired 1 bakery-café from a Florida franchisee. As of January 2015, Panera Bread had agreements with 37 franchise groups that operated 955 bakery-cafés. Panera’s largest franchisee operated nearly 200 bakery-cafés in Ohio, Pennsylvania, West Virginia, Kentucky, and Florida. The company’s franchise groups had committed to opening an additional 106 bakery-cafés. If a franchisee failed to develop bakery-cafés on schedule, Panera had the right to terminate the franchise agreement and develop its own company-operated locations or develop locations through new franchisees in that market. However, Panera from time to time agreed to modify the commitments of franchisees to open new locations when unfavorable market conditions or other circumstances warranted the postponement or cancellation of new unit openings. Panera provided its franchisees with support in a number of areas: market analysis and site selection assistance, lease review, design services and new store opening assistance, a comprehensive 10-week initial training program, a training program for hourly employees, manager and baker certification, bakery-café certification, continuing education classes, benchmarking data regarding costs and profit margins, access to company-developed marketing and advertising programs, neighborhood marketing assistance, and calendar planning assistance. Site Selection and Café Environment Bakery-cafés were typically located in suburban, strip mall, and regional mall locations. In evaluating 314  Part 2  Cases in Crafting and Executing Strategy EXHIBIT 6 Estimated Initial Investment for a Franchised Panera Bread Bakery-Café, 2012 Investment Category Actual or Estimated Amount To Whom Paid Development fee $5,000 per bakery-café contracted for in the franchisee’s Area Development Agreement $35,000 ($5,000 of the development fee was applied to the $35,000 franchise fee when a new bakery-café was opened) Varies according to site and local real estate market conditions $334,000 to $938,500 $198,000 to $310,000 $32,000 to $54,000 $28,500 to $62,000 $51,500 to $200,250 Panera $19,150 to $24,350 $24,000 to $29,000 $15,000 to $84,000 $175,000 to $245,000 Panera, other suppliers Suppliers Suppliers Vendors, suppliers, employees, utilities, landlord, others Franchise fee Real property Leasehold improvements Equipment Fixtures Furniture Consultant fees and municipal impact   fees (if any) Supplies and inventory Smallwares Signage Additional funds (for working capital   and general operating expenses   for 3 months)  Total Panera Contractors Equipment vendors, Panera Vendors Vendors Architect, engineer, expeditor, others $917,150 to $1,984,100, plus real estate and related costs Source:, accessed April 5, 2012. a potential location, Panera studied the surrounding trade area, demographic information within that area, and information on nearby competitors. Based on analysis of this information, including utilization of predictive modeling using proprietary software, Panera developed projections of sales and return on investment for candidate sites. Cafés had proven successful as free-standing units and as both inline and end-cap locations in strip malls and large regional malls. The average Panera bakery-café size was approximately 4,500 square feet. Most all company-operated locations were leased. Lease terms were typically for 10 years, with one, two, or three 5-year renewal option periods. Leases typically entailed charges for minimum base occupancy, a proportionate share of building and common area operating expenses and real estate taxes, and a contingent percentage rent based on sales above a stipulated amount. Some lease agreements provided for scheduled rent increases during the lease term. The average construction, equipment, furniture and fixture, and signage cost for the 65 company-owned bakery-cafés opened in 2014 was $1,400,000 (excluding capitalized development overhead expenses), compared to average costs of $750,000 for 42 company-owned bakerycafés opened in 2010 and $920,000 for 66 companyowned bakery-cafés opened in 2005. Each bakery-café sought to provide a distinctive and engaging environment (what management referred to as “Panera Warmth”), in many cases using fixtures and materials complementary to the neighborhood location of the bakery-café. All Panera cafés used real china and stainless silverware, instead of paper plates and plastic utensils. In 2005–2006, the company had introduced a new café design aimed at further refining and enhancing the appeal of Panera bakery-cafés as a warm and appealing neighborhood gathering place. The design incorporated higher-quality furniture, cozier seating, comfortable gathering areas, and relaxing décor. A number of locations had fireplaces to further create an alluring and hospitable atmosphere that patrons would flock to on a regular basis, sometimes for a Case 5  Panera Bread Company in 2015—What to Do to Rejuvenate the Company’s Growth?   315 meal with or without friends and acquaintances and sometimes to take a break for a light snack or beverage. Many locations had outdoor seating, and all company-operated and most franchised locations had free wireless Internet to help make the bakerycafés community gathering places where people could catch up on some work, hang out with friends, read the paper, or just relax (a strategy that Starbucks had used with great success). In 2006, Panera began working on store designs and operating systems that would enable free-standing and end-cap locations to incorporate a drive-thru window. In 2010–2011, increasing numbers of newly opened locations, both company-owned and franchised, featured drive-thru windows. Some existing units had undergone renovation to add a drive-thru window. Going into 2012, about 50 Panera Bread locations had drive-thru windows. Sales at these locations ran about 20 percent higher on average than units without drive-thru capability. Bakery-Café Operations Panera’s top executives believed that operating excellence was the most important element of Panera Warmth and that without strong execution and operational skills and energized café personnel who were motivated to provide pleasing service, it would be difficult to build and maintain a strong relationship with the customers patronizing its bakery-cafés. Additionally, top management believed high-quality restaurant management was critical to the company’s long-term success. Bakery-café managers were provided with detailed operations manuals, and all café personnel received hands-on training, both in small group and individual settings. The company had created systems to educate and prepare café personnel to respond to a customer’s questions and do their part to create a better dining experience. Management strived to maintain adequate staffing at each café and had instituted competitive compensation for café managers and both full-time and part-time café personnel (who were called associates). Panera executives had established a “Joint Venture Program,” whereby selected general managers and multi-unit managers of company-operated bakery cafés could participate in a bonus program based upon a percentage of the store profit of the bakery-cafés they operated. The bonuses were based on store profit percentages generally covering a period of five years, and the percentages were subject to annual minimums and maximums. Panera management believed the program’s multiyear approach (a) improved operator quality and management retention, (b) created team stability that generally resulted in a higher level of operating consistency and customer service for a particular bakery-café, (c) fostered a low rate management turnover, and (d) helped drive operating improvements at the company’s bakery-cafés. In 2013–2014, approximately 45 percent of the bakery-café operators Panera’s company-owned locations participated in the Joint Venture Program. Going into 2014, Panera Bread had approximately 45,400 employees. Approximately 42,700 were employed in Panera’s bakery-cafe operations as bakers, managers, and associates, approximately 1,400 were employed in the fresh dough facility operations, and approximately 1,300 were employed in general or administrative functions, principally in the company’s support centers. Roughly 25,500 employees worked, on average, at least 25 hours per week. Panera had no collective bargaining agreements with its associates and considered its employee relations to be good. Panera’s Bakery-Café Supply Chain Panera operated a network of 24 facilities (22 company-owned and 2 franchise-operated) to supply fresh dough for breads and bagels on a daily basis to almost all of its company-owned and franchised bakery-cafés; one of the company’s 22 facilities was a limited production operation co-located at a company-owned bakery-café in Ontario, Canada, that supplied dough to 12 Panera bakery-cafés in that market. All of the company’s facilities were leased. Most of the 1,400 employees at these facilities were engaged in preparing dough for breads and bagels, a process that took about 48 hours. The dough-making process began with the preparation and mixing of starter dough, which then was given time to rise; other all-natural ingredients were then added to create the dough for each of the different bread and bagel varieties (no chemicals or preservatives were used). Another period of rising then took 316  Part 2  Cases in Crafting and Executing Strategy place. Next, the dough was cut into pieces, shaped into loaves or bagels, and readied for shipment in fresh dough form. There was no freezing of the dough, and no partial baking was done at the fresh dough facilities. Trained bakers at each bakery-café performed all of the baking activities, using the fresh doughs delivered daily. Distribution of the fresh bread and bagel doughs (along with tuna, cream cheese spreads, and certain fresh fruits and vegetables) was accomplished through a leased fleet of about 225 temperaturecontrolled trucks operated by Panera personnel. The optimal maximum distribution route was approximately 300 miles; however, routes as long as 500 miles were sometimes necessary to supply cafés in outlying locations. In 2013–2014, the various distribution routes for regional facilities entailed making daily deliveries to eight to nine bakery-cafés. Panera obtained ingredients for its doughs and other products manufactured at its regional facilities. While a few ingredients used at these facilities were sourced from a single supplier, there were numerous suppliers of each ingredient needed for fresh dough and cheese spreads. Panera contracted externally for the manufacture and distribution of sweet goods to its bakery-cafés. After delivery, sweet good products were finished with fresh toppings and other ingredients (based on Panera’s own recipes) and baked to Panera’s artisan standards by professionally trained bakers at each café location. Panera had arrangements with several independent distributors to handle the delivery of sweet goods products and other items to its bakery-cafés, but the company had contracted with a single supplier to deliver the majority of ingredients and other products to its bakery-cafés two or three times weekly. Virtually all other food products and supplies for their bakery-cafés, including paper goods, coffee, and smallwares, were contracted for by Panera and delivered by the vendors to designated independent distributors for delivery to the bakerycafés. Individual bakery-cafés placed orders for the needed supplies directly with a distributor; distributors made deliveries to bakery-cafés two or three times per week. Panera maintained a list of approved suppliers and distributors that all company-owned and franchised cafés could select from in obtaining food products and other supplies not sourced from the company’s regional facilities or delivered directly by contract suppliers. Although many of the ingredients and menu items sourced from outside vendors were prepared to Panera’s specifications, the ingredients for a big majority of menu selections were generally available and could be obtained from alternative sources when necessary. In a number of instances, Panera had entered into annual and multiyear contracts for certain ingredients in order to decrease the risks of supply interruptions and cost fluctuation. However, Panera had only a limited number of suppliers of antibiotic-free chicken; because there were relatively few producers of meat products raised without ­antibiotics—as well as certain other organically grown items—it was difficult or more costly for Panera to find alternative suppliers. Management believed the company’s fresh dough-making capability provided a competitive advantage by ensuring consistent quality and dough-making efficiency (it was more economical to concentrate the dough-making operations in a few facilities dedicated to that function than it was to have each bakery-café equipped and staffed to do all of its baking from scratch). Management also believed that the company’s growing size and scale of operations gave it increased bargaining power and leverage with suppliers to improve ingredient quality and cost, and that its various supply-chain arrangements entailed little risk that its bakery-cafés would experience significant delivery interruptions from weather conditions or other factors that would adversely affect café operations. The fresh dough made at the regional facilities was sold to both company-owned and franchised bakery-cafés at a delivered cost not to exceed 27 percent of the retail value of the product. Exhibit 7 provides financial data relating to each of Panera’s three business segments: company-operated bakerycafés, franchise operations, and the operations of the regional facilities that supplied fresh dough and other products. The sales and operating profits of the fresh dough and other products segment shown in Exhibit 7 represent only those transactions with franchised bakery-cafés. The company classified any operating profit of the regional facilities stemming from supplying fresh dough and other products to company-owned bakery-cafés as a reduction Case 5  Panera Bread Company in 2015—What to Do to Rejuvenate the Company’s Growth?   317 EXHIBIT 7 Business Segment Information, Panera Bread Company, 2009–2014 (in thousands of dollars) Segment revenues: Company bakery-café operations Franchise operations Fresh dough and other product   operations at regional facilities Intercompany sales eliminations Total revenues Segment operating profit: Company bakery-café operations Franchise operations Fresh dough and other product   operations at regional facilities Total segment operating profit Depreciation and amortization: Company bakery-café operations Fresh dough and other product   operations at regional facilities Corporate administration Total Capital expenditures: Company bakery-café operations Fresh dough and other product   operations at regional facilities Corporate administration Total capital expenditures Segment assets: Company bakery-café operations Franchise operations Fresh dough and other product   operations at regional facilities Total segment assets 2014 2013 2012 2011 2009 $2,230,370 123,686 $2,108,908 112,641 $1,879,280 102,076 $1,592,951 92,793 $1,153,255 78,367 370,004 (194,865) $2,529,195 347,922 (184,469) $2,385,002 312,308 (163,607) $2,130,057 275,096 (138,808) $1,822,032 216,116 (94,244) $1,353,494 $400,261 117,770 $413,474 106,395 $380,432 95,420 $307,012 86,148 $193,669 72,381 22,872 $540,903 21,293 $541,162 17,695 $493,547 20,021 $413,181 21,643 $287,693 $103,239 $ 90,872 $78,198 $68,651 $55,726 8,613 12,257 $124,109 8,239        7,412 $106,523 6,793      5,948 $90,939 6,777      4,471 $79,899 7,620      3,816 $67,162 $167,856 $153,584 $122,868 $ 94,873 $46,408 13,434 16,026 $152,328 6,483     6,576 $107,932 3,681     4,595 $54,684     12,178 44,183 $224,217   11,461 26,965 $192,010   $953,896 13,145 $867,093 10,156 $807,681 10,285 $682,246 7,502 $498,806 3,850       65,219 $1,390,902  62,854 $940,103   60,069 $878,035   47,710 $737,458   48,616 $551,272 Source: Panera Bread’s 2014 10-K Report, p. 66; 2013 10-K Report, p. 67; and 2011 10-K Report, p. 69. in the cost of food and paper products. The costs of food and paper products for company-operated bakery-cafés are shown in Exhibit 1. Panera Bread’s Management Information Systems Each company-owned bakery-café had programmed point-of-sale registers that collected transaction data used to generate transaction counts, product mix, average check size, and other pertinent statistics. The prices of menu selections at all company-owned bakery-cafés were programmed into the point-ofsale registers from the company’s data support centers. Franchisees were allowed access to certain parts of Panera’s proprietary bakery-café systems and systems support; they were responsible for providing the appropriate menu prices, discount rates, and tax rates for system programming. The company used in-store enterprise application tools and the capabilities of the Panera 2.0 app to (1) assist café managers in scheduling work hours 318  Part 2  Cases in Crafting and Executing Strategy for café personnel and controlling food costs in order to provide corporate and retail operations management with quick access to retail data, (2) enable café managers to place online orders with distributors, and (3) reduce the time café managers spent on administrative activities. The information collected electronically at café registers was used to generate daily and weekly consolidated reports regarding sales, transaction counts, average check size, product mix, sales trends, and other operating metrics, as well as detailed profit-and-loss statements for company-owned bakery-cafés. This data was incorporated into the company’s “exception-based reporting” tools. Panera’s regional facilities had software that accepted electronic orders from bakery-cafés and monitored delivery of the ordered products back to the bakery-cafés. Panera also had developed proprietary digital software to provide online training to employees at bakery-cafés and online baking instructions for the baking personnel at each café. Most of Panera’s bakery-cafés provided customers with free Internet access through a managed WiFi network that was among the largest free public WiFi networks in the United States. New Developments at Panera Bread, April 2015 In mid-April 2015, following a “constructive dialogue” with activist shareholder Luxor Capital Group, Panera Bread announced that it would (a) expand its share-repurchase plan from $600 million to $750 million, (b) sell 73 of its 925 companyowned bakery-cafés to franchisees to raise money to help fund the added expenditures on repurchasing outstanding shares of the company’s common stock, and (c) borrow $500 million to help fund the sharebuyback plan. Panera’s stock price jumped nearly 12 percent on the day of the announcement. In February 2015, Panera had warned that it expected earnings per share in 2015 would, at best, be flat in comparison to the $6.64 the company earned in 2014. Luxor, a hedge fund based in New York, had previously been a part of an activist shareholder group that had prodded another restaurant chain to make operating improvements and repurchase shares of stock, partly using debt to fund the share buyback. Analysts said the pressure Luxor put on Panera could spur management to increase its efforts to make needed operating improvements in its stores: some diners and Panera’s bakery cafés had complained about long lines to pay for food and slow delivery of orders to diners’ tables. While Panera’s rollout of Panera 2.0 was intended to speed service and checkout, as well as enable other operating efficiencies, some investors were concerned that Panera 2.0 was being implemented too slowly and were skeptical whether the new software would actually improve internal operating efficiency and boost customer traffic outside the lunch hour by as much as Panera executives hoped. The Restaurant Industry in the United States According to the National Restaurant Association, total food-and-drink sales at some 1 million food service locations of all types in the United States were projected to reach a record $709 billion in 2014, up 3.8 percent over 2014 and up from $379 billion in 2000 and $239 billion in 1990.11 Of the projected $709 billion in food-and-drink sales industry-wide in 2014, about $471 billion were expected to occur in commercial restaurants, with the remainder divided among bars and taverns, lodging place restaurants, managed food service locations, military restaurants, and other types of retail, vending, recreational, and mobile operations with food service capability. In 2012, unit sales averaged $875,000 at full-service restaurants and $803,000 at quick-service restaurants; however, very popular restaurant locations achieved annual sales volumes in the $2.5 million to $5 million range. Restaurants were the nation’s second largest private employer in 2014 with almost 14 million employees. Nearly half of all adults in the United States had worked in the restaurant industry at some point in their lives, and close to one out of three adults got their first job experience in a restaurant. More than 90 percent of all eating-and-drinking place businesses had fewer than 50 employees, and more than 70 percent of these places were singleunit operations. Even though the average U.S. consumer ate 76 percent of their meals at home, on a typical day, Case 5  Panera Bread Company in 2015—What to Do to Rejuvenate the Company’s Growth?   319 about 130 million U.S. consumers were food service patrons at an eating establishment. Sales at commercial eating places were projected to average about $1.9 billion daily in 2015. Average household expenditures for food away from home in 2013 were $2,625, equal to about 40 percent of total household expenditures for food.12 The restaurant business was labor-intensive, extremely competitive, and risky. Industry members pursued differentiation strategies of one variety of another, seeking to set themselves apart from rivals via pricing, food quality, menu theme, signature menu selections, dining ambiance and atmosphere, service, convenience, and location. To further enhance their appeal, some restaurants tried to promote greater customer traffic via happy hours, lunch and dinner specials, children’s menus, innovative or trendy dishes, diet-conscious menu selections, and beverage/appetizer specials during televised sporting events (important at restaurants/bars with bigscreen TVs). Most restaurants were quick to adapt their menu offerings to changing consumer tastes and eating preferences, frequently featuring hearthealthy, vegetarian, organic, low-calorie, and/or low-carb items on their menus. Research conducted by the National Restaurant Industry in 2014 indicated that:13 ∙ 64 percent of consumers considered themselves to be more adventurous in their restaurant food choices than they were two years ago. ∙ 76 percent of consumers were more likely to visit a restaurant that offered healthy menu options. ∙ 79 percent of consumers say restaurant technology increases convenience. It was the norm at many restaurants to rotate some menu selections seasonally and to periodically introduce creative dishes in an effort to keep regular patrons coming back, attract more patrons, and remain competitive. The profitability of a restaurant location ranged from exceptional to good to average to marginal to money-losing. Consumers (especially those that ate out often) were prone to give newly opened eating establishments a trial, and if they were pleased with their experience, they might return, sometimes frequently; loyalty to existing restaurants was low when consumers perceived there were better dining alternatives. It was also common for a once-hot restaurant to lose favor and confront the stark realities of a dwindling clientele, forcing it to either reconceive its menu and dining environment or go out of business. Many restaurants had fairly short lives. There were multiple causes for a restaurant’s failure: a lack of enthusiasm for the menu or dining experience, inconsistent food quality, poor service, a poor location, meal prices that patrons deemed too high, and being outcompeted by rivals with comparable menu offerings. ENDNOTES 1 8 mation posted at (accessed March 7, 2014). 9 Harris Interactive press releases, March 16, 2011 and May 10, 2012, and infor- Ibid. Jim Salter, “Panera Suspends Latest Pay-What-You-Can Experiment in Stores,” “Zagat Announces 2012 Fast-Food Survey Results,”, September 27, 2012 (accessed March 7, 2014). 3 Sandelman and Associates Quick-Track surveys and Fast-Food Awards of Excellence Winners, and information included in “Press Kit” posted at, July 10, 2013 (accessed March 7, 2014). (accessed March 7, 2014). (accessed July 26, 2011, April 8, 2012, and March 18, 2 4 As stated in a presentation to securities analysts, May 5, 2006. 5 Ron Ruggless, “Panera Cares: One Year Later,” Nation’s Restaurant News, May 16, 2011, posted at (accessed July 19, 2011). 6 Sean Gregory-Clayton, “Sandwich Philanthropy,” Time, August 2, 2010, posted at (accessed July 19, 2011). 7 Annie Gasparro, “A New Test for Panera’s Pay-What-You-Can,” Wall Street Journal, June 4, 2013, posted at (accessed March 7, 2014). 10 As cited in Panera Bread’s presentation to securities analysts on May 5, 2006. 11 The statistical data in this section is based on information posted at 2015). 12 Bureau of Labor Statistics, news release, September 9, 2014 (accessed at, March 18, 2015). 13 National Restaurant Industry, “2015 Restaurant Industry Pocket Factbook,” posted at  (accessed March 18, 2015).v
The Five Generic Competitive Strategies chapter 5 LEARNING OBJECTIVES LO1 Understand what distinguishes each of the five generic strategies and why some of these strategies work better in certain kinds of industry and competitive conditions than in others. LO2 Learn the major avenues for achieving a competitive advantage based on lower costs. LO3 Gain command of the major avenues for developing a competitive advantage based on differentiating a company’s product or service offering from the offerings of rivals. LO4 Recognize the required conditions for delivering superior value to customers through the use of a hybrid of low-cost provider and differentiation strategies. 89 90  Part 1  Section C: Crafting a Strategy There are several basic approaches to competing successfully and gaining a competitive advantage, but they all involve giving buyers what they perceive as superior value compared to the offerings of rival sellers. A superior value proposition can be based on offering a good product at a lower price, a superior product that is worth paying more for, or a best-value offering that represents an attractive combination of price, features, quality, service, and other appealing attributes. This chapter describes the five generic competitive strategy options for building competitive advantage and delivering superior value to customers. Which of the five to employ is a company’s first and foremost choice in crafting an overall strategy and beginning its quest for competitive advantage. LO1   Understand what distinguishes each of the five generic strategies and why some of these strategies work better in certain kinds of industry and competitive conditions than in others. The Five Generic Competitive Strategies A company’s competitive strategy deals exclusively with the specifics of management’s game plan for competing successfully—its specific efforts to please customers, strengthen its market position, counter the maneuvers of rivals, respond to shifting market conditions, and achieve a particular competitive advantage. The chances are remote that any two companies—even companies in the same industry—will employ competitive strategies that are exactly alike. However, when one strips away the details to get at the real substance, the two biggest factors that distinguish one competitive strategy from another boil CORE CONCEPT down to (1) whether a company’s market target is broad A competitive strategy concerns the specifics or narrow, and (2) whether the company is pursuing a of management’s game plan for competing succompetitive advantage linked to lower costs or differencessfully and securing a competitive advantage tiation. These two factors give rise to the five competiover rivals in the marketplace. tive strategy options shown in Figure 5.1.1 Market Coverage FIGURE 5.1  The Five Generic Competitive Strategies Presence in a Broad Range of Market Segments Overall Low-Cost Provider Strategy Broad Differentiation Strategy Best-Cost Provider Strategy Presence in a Limited Number of Market Segments Focused Low-Cost Strategy Value Creation Keyed to Lower Cost Focused Differentiation Strategy Value Creation Keyed to Differentiating Features Type of Competitive Advantage Pursued Source: This is an author-expanded version of a three-strategy classification discussed in Michael E. Porter, Competitive Strategy (New York: Free Press, 1980), pp. 35–40. Chapter 5  The Five Generic Competitive Strategies   91 1. A low-cost provider strategy—striving to achieve lower overall costs than rivals and appealing to a broad spectrum of customers, usually by underpricing rivals 2. A broad differentiation strategy—seeking to differentiate the company’s product or service from rivals’ in ways that will appeal to a broad spectrum of buyers 3. A focused low-cost strategy—concentrating on a narrow buyer segment (or market niche) and outcompeting rivals by having lower costs than rivals and thus being able to serve niche members at a lower price 4. A focused differentiation strategy—concentrating on a narrow buyer segment (or market niche) and outcompeting rivals by offering niche members customized attributes that meet their tastes and requirements better than rivals’ products 5. A best-cost provider strategy—giving customers more value for the money by satisfying buyers’ expectations on key quality/features/performance/service attributes while beating their price expectations. This option is a hybrid strategy that blends elements of low-cost provider and differentiation strategies; the aim is to have the lowest (best) costs and prices among sellers offering products with comparable differentiating attributes. The remainder of this chapter explores the ins and outs of the five generic competitive strategies and how they differ. Low-Cost Provider Strategies LO2   Learn the major avenues for achieving a competitive advantage based on lower costs. Striving to be the industry’s overall low-cost provider is a powerful competitive approach in markets with many price-sensitive buyers. A company achieves low-cost leadership when it becomes the industry’s lowest-cost provider rather than just being one of perhaps several competiCORE CONCEPT tors with low costs. Successful low-cost providers boast A low-cost leader’s basis for competitive advanmeaningfully lower costs than rivals, but not necessarily tage is lower overall costs than competitors’. the absolutely lowest possible cost. In striving for a cost Success in achieving a low-cost edge over rivals advantage over rivals, managers must include features comes from eliminating and/or curbing “nonesand services that buyers consider essential. A product sential” activities and/or outmanaging rivals in offering that is too frills-free can be viewed by consumperforming essential activities. ers as offering little value, regardless of its pricing. A company has two options for translating a low-cost advantage over rivals into attractive profit performance. Option 1 is to use the lower-cost edge to underprice competitors and attract price-sensitive buyers in great enough numbers to increase total profits. Option 2 is to maintain the present price, be content with the present market share, and use the lower-cost edge to earn a higher profit margin on each unit sold, thereby raising the firm’s total profits and overall return on investment. The Two Major Avenues for Achieving Low-Cost Leadership To achieve a low-cost edge over rivals, a firm’s cumulative costs across its overall value chain must be lower than competitors’ cumulative costs. There are two major avenues for accomplishing this:2 1. Performing essential value chain activities more cost-effectively than rivals. 2. Revamping the firm’s overall value chain to eliminate or bypass some cost-­ producing activities. 92  Part 1  Section C: Crafting a Strategy Cost-Efficient Management of Value Chain Activities  For a company to do a more cost-efficient job of managing its value chain than rivals, managers must launch a concerted, ongoing effort to ferret out cost-saving opportunities in every part of the value chain. No activity can escape cost-saving scrutiny, and all company personnel must be expected to use their talents and ingenuity to come up with innovative and effective ways to keep costs down. Particular attention needs to be paid to cost drivers, which are factors that have an especially strong effect on the costs of a company’s value chain activities. The number of products in a company’s product line, its capacity utilization, the type of components used in the assembly of its products, and the extent of its employee benefits package are all facCORE CONCEPT tors affecting the company’s overall cost position. Figure A cost driver is a factor having a strong effect on 5.2 shows the most important cost drivers. Cost-saving the cost of a company’s value chain activities and approaches that demonstrate effective management of cost structure. the cost drivers in a company’s value chain include: ∙ Striving to capture all available economies of scale. Economies of scale stem from an ability to lower unit costs by increasing the scale of operation. For example, Anheuser-Busch InBev was able to capture scale economies with its $4 million SuperBowl ad in 2014 because the cost could be distributed over the 370 millions of cases of Budweiser and Bud Light sold that year. ∙ Taking full advantage of experience and learning curve effects. The cost of performing an activity can decline over time as the learning and experience of company personnel build. FIGURE 5.2  Important Cost Drivers in a Company’s Value Chain Labor productivity and compensation costs Economies of scale Outsourcing or vertical integration Learning and experience COST DRIVERS Bargaining power Communication systems and information technology Production technology and design Capacity utilization Input costs Sources: Adapted by the authors from M. Porter, The Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985). Chapter 5  The Five Generic Competitive Strategies   93 ∙ Trying to operate facilities at full capacity. Whether a company is able to operate at or near full capacity has a big impact on unit costs when its value chain contains activities associated with substantial fixed costs. Higher rates of capacity utilization allow depreciation and other fixed costs to be spread over a larger unit volume, thereby lowering fixed costs per unit. ∙ Substituting lower-cost inputs whenever there’s little or no sacrifice in product quality or product performance. If the costs of certain raw materials and parts are “too high,” a company can switch to using lower-cost alternatives when they exist. ∙ Employing advanced production technology and process design to improve overall efficiency. Often production costs can be cut by utilizing design for manufacture (DFM) procedures and computer-assisted design (CAD) techniques that enable more integrated and efficient production methods, investing in highly automated robotic production technology, and shifting to production processes that enable manufacturing multiple versions of a product as cost efficiently as mass producing a single version. A number of companies are ardent users of total quality management systems, business process reengineering, Six Sigma methodology, and other business process management techniques that aim at boosting efficiency and reducing costs. ∙ Using communication systems and information technology to achieve operating efficiencies. For example, sharing data and production schedules with suppliers, coupled with the use of enterprise resource planning (ERP) and manufacturing execution system (MES) software, can reduce parts inventories, trim production times, and lower labor requirements. ∙ Using the company’s bargaining power vis-à-vis suppliers to gain concessions. A company may have sufficient bargaining clout with suppliers to win price discounts on large-volume purchases or realize other cost savings. ∙ Being alert to the cost advantages of outsourcing and vertical integration. Outsourcing the performance of certain value chain activities can be more economical than performing them in-house if outside specialists, by virtue of their expertise and volume, can perform the activities at lower cost. ∙ Pursuing ways to boost labor productivity and lower overall compensation costs. A company can economize on labor costs by using incentive compensation systems that promote high productivity, installing labor-saving equipment, shifting production from geographic areas where pay scales are high to geographic areas where pay scales are low, and avoiding the use of union labor where possible (because costly work rules can stifle productivity and because of union demands for above-market pay scales and costly fringe benefits). Revamping the Value Chain  Dramatic cost advantages can often emerge from reengineering the company’s value chain in ways that eliminate costly work steps and bypass certain cost-producing value chain activities. Such value chain revamping can include: ∙ Selling directly to consumers and cutting out the activities and costs of distributors and dealers. To circumvent the need for distributors–dealers, a company can (1) create its own direct sales force (which adds the costs of maintaining and supporting a sales force but may be cheaper than utilizing independent distributors 94  Part 1  Section C: Crafting a Strategy and dealers to access buyers), and/or (2) conduct sales operations at the company’s website (costs for website operations and shipping may be a substantially cheaper way to make sales to customers than going through distributor–dealer channels). Costs in the wholesale/retail portions of the value chain frequently represent 35 to 50 percent of the price final consumers pay, so establishing a direct sales force or selling online may offer big cost savings. ∙ Streamlining operations by eliminating low-value-added or unnecessary work steps and activities. Southwest Airlines has achieved considerable cost savings by reconfiguring the traditional value chain of commercial airlines to eliminate lowvalue-added activities and work steps. Southwest does not offer assigned seating, baggage transfer to connecting airlines, or first-class seating and service, thereby eliminating all the cost-producing activities associated with these features. Also, the company’s carefully designed point-to-point route system minimizes connections, delays, and total trip time for passengers, allowing about 75 percent of Southwest passengers to fly nonstop to their destinations and at the same time helping reduce Southwest’s costs for flight operations. ∙ Improving supply chain efficiency to reduce materials handling and shipping costs. Collaborating with suppliers to streamline the ordering and purchasing process, to reduce inventory carrying costs via just-in-time inventory practices, to economize on shipping and materials handling, and to ferret out other cost-saving opportunities is a much-used approach to cost reduction. A company with a distinctive competence in cost-efficient supply chain management, such as BASF (the world’s leading chemical company), can sometimes achieve a sizable cost advantage over less adept rivals. Concepts & Connections 5.1 describes Walmart’s broad approach to managing its value chain in the retail grocery portion of its business to achieve a dramatic cost advantage over rival supermarket chains and become the world’s biggest grocery retailer. When a Low-Cost Provider Strategy Works Best A competitive strategy predicated on low-cost leadership is particularly powerful when: 1. Price competition among rival sellers is especially vigorous. Low-cost providers are in the best position to compete offensively on the basis of price and to survive price wars. 2. The products of rival sellers are essentially identical and are readily available from several sellers. Commodity-like products and/or ample supplies set the stage for lively price competition; in such markets, it is the less efficient, higher-cost companies that are most vulnerable. 3. There are few ways to achieve product differentiation that have value to buyers. When the product or service differences between brands do not matter much to buyers, buyers nearly always shop the market for the best price. 4. Buyers incur low costs in switching their purchases from one seller to another. Low switching costs give buyers the flexibility to shift purchases to lower-priced sellers having equally good products. A low-cost leader is well positioned to use low price to induce its customers not to switch to rival brands. Chapter 5  The Five Generic Competitive Strategies   95 & Concepts Connections 5.1 HOW WALMART MANAGED ITS VALUE CHAIN TO ACHIEVE A LOW-COST ADVANTAGE OVER RIVAL SUPERMARKET CHAINS Walmart has achieved a very substantial cost and pricing advantage over rival supermarket chains by both revamping portions of the grocery retailing value chain and outmanaging its rivals in efficiently performing various value chain activities. Its cost advantage stems from a series of initiatives and practices: • Instituting extensive information sharing with vendors via online systems that relay sales at its checkout counters directly to suppliers of the items, thereby providing suppliers with real-time information on customer demand and preferences (creating an estimated 6 percent cost advantage). • Pursuing global procurement of some items and centralizing most purchasing activities so as to leverage the company’s buying power (creating an estimated 2.5 percent cost advantage). • Investing in state-of-the-art automation at its distribution centers, efficiently operating a truck fleet that makes daily deliveries to Walmart’s stores, and putting assorted other cost-saving practices into place at its headquarters, distribution centers, and stores (resulting in an estimated 4 percent cost advantage). • Striving to optimize the product mix and achieve greater sales turnover (resulting in about a 2 percent cost advantage). • Installing security systems and store operating procedures that lower shrinkage rates (producing a cost advantage of about 0.5 percent). • Negotiating preferred real estate rental and leasing rates with real estate developers and owners of its store sites (yielding a cost advantage of 2 percent). • Managing and compensating its workforce in a manner that produces lower labor costs (yielding an estimated 5 percent cost advantage). Altogether, these value chain initiatives give Walmart an approximately 22 percent cost advantage over Kroger, Safeway, and other leading supermarket chains. With such a sizable cost advantage, Walmart has been able to underprice its rivals and become the world’s leading supermarket retailer. To maintain its cost advantages, which are very much tied to scale and growth, Walmart has adapted to more broadly reach a changing and growing customer base. Walmart stores range from giant, 24-hour Supercenters to Neighborhood Markets and Express stores that better fit the needs of customers in urban or fast-moving locales.  In the same way, the company has tailored its international expansion by country.  With further innovation in online and fresh delivery sales, Walmart is well poised to continue its growth and low-cost leadership. Sources:; and Marco Iansiti and Roy Levien, “Strategy as Ecology,” Harvard Business Review 82, no. 3 (March 2004), p. 70; and Clare O’Connor, “Walmart vs. Amazon: World’s Biggest E-Commerce Battle Could Boil Down to Vegetables,” Forbes Online, March 2014. 5. The majority of industry sales are made to a few, large-volume buyers. Low-cost providers are in the best position among sellers in bargaining with high-volume buyers because they are able to beat rivals’ pricing to land a high-volume sale while maintaining an acceptable profit margin. 6. Industry newcomers use introductory low prices to attract buyers and build a customer base. The low-cost leader can use price cuts of its own to make it harder for a new rival to win customers. As a rule, the more price-sensitive buyers are, the more appealing a low-cost strategy becomes. A low-cost company’s ability to set the industry’s price floor and still earn a profit erects protective barriers around its market position. Pitfalls to Avoid in Pursuing a Low-Cost Provider Strategy Perhaps the biggest pitfall of a low-cost provider strategy is getting carried away with overly aggressive price cutting and ending up with lower, rather than higher, profitability. 96  Part 1  Section C: Crafting a Strategy A low-cost/low-price advantage results in superior profitability only if (1) prices are cut by less than the size of the cost advantage or (2) the added volume is large enough to bring in a bigger total profit despite lower margins per unit sold. Thus, a company with a 5 percent cost advantage cannot cut prices 20 percent, end up with a volume gain of only 10 percent, and still expect to earn higher profits! A second big pitfall is relying on an approach to reduce costs that can be easily copied by rivals. The value of a cost advantage depends on its sustainability. Sustainability, in turn, hinges on whether the company achieves its cost advantage in ways difficult for rivals to replicate or match. If rivals find it relatively easy or inexpensive to imitate the leader’s low-cost methods, then the leader’s advantage will be too shortlived to yield a valuable edge in the marketplace. A third pitfall is becoming too fixated on cost reduction. Low costs cannot be pursued so zealously that a firm’s offering ends up being too features-poor to gain the interest of buyers. Furthermore, a company driving hard to push its costs down has to guard against misreading or ignoring increased buyer preferences for added features or declining buyer price sensitivity. Even if these mistakes are avoided, a low-cost competitive approach still carries risk. Cost-saving technological breakthroughs or process improvements by rival firms can nullify a low-cost leader’s hard-won position. Broad Differentiation Strategies Differentiation strategies are attractive whenever buyers’ needs and preferences are too diverse to be fully satisfied by a standardized product or service. A The essence of a broad differentiation strategy is to offer unique product or service attributes that company attempting to succeed through differentiaa wide range of buyers find appealing and worth tion must study buyers’ needs and behavior carefully paying for. to learn what buyers think has value and what they are willing to pay for. Then the company must include these desirable features to clearly set itself apart from rivals lacking such product or service attributes. Successful differentiation allows a firm to: CORE CONCEPT ∙ Command a premium price, and/or ∙ Increase unit sales (because additional buyers are won over by the differentiating features), and/or ∙ Gain buyer loyalty to its brand (because some buyers are strongly attracted to the differentiating features and bond with the company and its products). LO3   Gain command of the major avenues for developing a competitive advantage based on differentiating a company’s product or service offering from the offerings of rivals. Differentiation enhances profitability whenever the extra price the product commands outweighs the added costs of achieving the differentiation. Company differentiation strategies fail when buyers don’t value the brand’s uniqueness and/or when a company’s approach to differentiation is easily copied or matched by its rivals. Approaches to Differentiation Companies can pursue differentiation from many angles: a unique taste (Red Bull, Doritos), multiple features (Microsoft Office, Apple iPhone), wide selection and one-stop shopping (Home Depot,, superior service (Ritz-Carlton, Nordstrom), spare parts availability (Caterpillar guarantees 48-hour spare parts delivery to any customer Chapter 5  The Five Generic Competitive Strategies   97 anywhere in the world or else the part is furnished free), engineering design and performance (Mercedes-Benz, BMW), luxury and prestige (Rolex, Gucci, Chanel), product reliability (Whirlpool and Bosch in large home appliances), quality manufacturing (Michelin in tires, Toyota and Honda in automobiles), technological leadership (3M Corporation in bonding and coating products), a full range of services (Charles Schwab in stock brokerage), and a complete line of products (Campbell soups, Frito-Lay snack foods). The most appealing approaches to differentiation are those that are hard or expensive for rivals to duplicate. Resourceful competitors can, in time, clone almost any product or feature or attribute. If Toyota introduces smartphone integration or backup cameras, so can Ford and Honda; if Firestone offers customers attractive financing terms, so can Goodyear. As a rule, differentiation yields a longer-lasting and more profitable competitive edge when it is based on product innovation, technical superiority, product quality and reliability, Easy-to-copy differentiating features cannot procomprehensive customer service, and unique competiduce sustainable competitive advantage; differentive capabilities. Such differentiating attributes tend tiation based on hard-to-copy competencies and to be tough for rivals to copy or offset profitably, and capabilities tends to be more sustainable. buyers widely perceive them as having value. Managing the Value Chain in Ways That Enhance Differentiation Success in employing a differentiation strategy results from management’s ability to offer superior customer value through the addition of product/service attributes and features that differentiate a company’s offering from the offerings of rivals. Differentiation opportunities can exist in activities all along an industry’s value chain and particularly in activities and factors that meaningfully impact customer value. Such activities are referred to as uniqueness drivers—analogous to cost drivers—but have a high impact on differentiation rather than on a company’s overall cost position. Figure 5.3 lists important CORE CONCEPT uniqueness drivers found in a company’s value chain. A uniqueness driver is a value chain activity or Ways that managers can enhance differentiation factor that can have a strong effect on customer through the systematic management of uniqueness value and creating differentiation. drivers include the following: ∙ Seeking out high-quality inputs. Input quality can ultimately spill over to affect the performance or quality of the company’s end product. Chipotle Mexican Grill, for example, gets excellent customer reviews at Yelp partly because of its very strict specifications for ingredients purchased from suppliers. ∙ Striving for innovation and technological advances. Successful innovation is the route to more frequent first-on-the-market victories and is a powerful differentiator. If the innovation proves hard to replicate, through patent protection or other means, it can provide a company with a first-mover advantage that is sustainable. ∙ Creating superior product features, design, and performance. The physical and functional features of a product have a big influence on differentiation. Styling and appearance are big differentiating factors in the apparel and motor vehicle industries. Graphics resolution and processing speed matter in video game consoles. Most companies employing broad differentiation strategies make a point of incorporating innovative and novel features in their product/service offering, especially those that improve performance. 98  Part 1  Section C: Crafting a Strategy FIGURE 5.3  Important Uniqueness Drivers in a Company’s Value Chain Input quality Innovation and technological advances Customer service Marketing and brandbuilding Employee skills, training, experience UNIQUENESS DRIVERS Continuous quality improvement Product features, design, and performance Production R&D Source: Adapted from M. Porter, The Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985). ∙ Investing in production-related R&D activities. Engaging in production R&D may permit custom-order manufacture at an efficient cost, provide wider product variety and selection, or improve product quality. Many manufacturers have developed flexible manufacturing systems that allow different models and product versions to be made on the same assembly line. Being able to provide buyers with made-to-order products can be a potent differentiating capability. ∙ Pursuing continuous quality improvement. Quality control processes reduce product defects, prevent premature product failure, extend product life, make it economical to offer longer warranty coverage, improve economy of use, result in more end-user convenience, enhance product appearance, or improve customer service. ∙ Emphasizing human resource management activities that improve the skills, expertise, and knowledge of company personnel. A company with high-caliber intellectual capital often has the capacity to generate the kinds of ideas that drive product innovation, technological advances, better product design and product performance, improved production techniques, and higher product quality. ∙ Increasing emphasis on marketing and brand-building activities. The manner in which a company conducts its marketing and brand management activities has a significant influence on customer perceptions of the value of a company’s product offering and the price customers will pay for it. A highly skilled and competent sales force, effectively communicated product information, eye-catching ads, Chapter 5  The Five Generic Competitive Strategies   99 in-store displays, and special promotional campaigns can all cast a favorable light on the differentiating attributes of a company’s product/service offering and contribute to greater brand-name awareness and brand-name power. ∙ Improving customer service or adding additional services. Better customer service, in areas such as delivery, returns, and repair, can be as important in creating differentiation as superior product features. Revamping the Value Chain System to Increase Differentiation  Just as pursuing a cost advantage can involve the entire value chain system, the same is true for a differentiation advantage. As was discussed in Chapter 4, activities performed upstream by suppliers or downstream by distributors and retailers can have a meaningful effect on customers’ perceptions of a company’s offerings and its value proposition. Approaches to enhancing differentiation through changes in the value chain system include: ∙ Coordinating with channel allies to enhance customer value. Coordinating with downstream partners such as distributors, dealers, brokers, and retailers can contribute to differentiation in a variety of ways. Many manufacturers work directly with retailers on in-store displays and signage, joint advertising campaigns, and providing sales clerks with product knowledge and tips on sales techniques—all to enhance customer buying experiences. Companies can work with distributors and shippers to ensure fewer “out-of-stock” annoyances, quicker delivery to customers, more-accurate order filling, lower shipping costs, and a variety of shipping choices to customers. ∙ Coordinating with suppliers to better address customer needs. Collaborating with suppliers can also be a powerful route to a more effective differentiation strategy. This is particularly true for companies that engage only in assembly operations, such as Dell in PCs and Ducati in motorcycles. Close coordination with suppliers can also enhance differentiation by speeding up new-product development cycles or speeding delivery to end customers. Strong relationships with suppliers can also mean that the company’s supply requirements are prioritized when industry supply is insufficient to meet overall demand. Delivering Superior Value via a Differentiation Strategy While it is easy enough to grasp that a successful differentiation strategy must offer value in ways unmatched by rivals, a big issue in crafting a differentiation strategy is deciding what is valuable to customers. Typically, value can be delivered to customers in three basic ways. 1. Include product attributes and user features that lower the buyer’s costs. Commercial buyers value products that can reduce their cost of doing business. For example, making a company’s product more economical for a buyer to use can be done by reducing the buyer’s raw materials waste (providing cut-to-size components), reducing a buyer’s inventory requirements (providing just-in-time deliveries), increasing product reliability to lower a buyer’s repair and maintenance costs, and providing free technical support. Similarly, consumers find value in differentiating features that will reduce their expenses. Rising costs for gasoline prices have spurred the efforts of motor vehicle manufacturers worldwide to introduce models with better fuel economy. 100  Part 1  Section C: Crafting a Strategy 2. Incorporate tangible features that improve product performance. Commercial buyers and consumers alike value higher levels of performance in many types of products. Product reliability, output, durability, convenience, and ease of use are aspects of product performance that differentiate products offered to buyers. Tablet computer manufacturers are currently in a race to develop next-generation tablets with the functionality and processing power to capturing market share from rivals and cannibalize the laptop computer market. 3. Incorporate intangible features that enhance buyer satisfaction in noneconomic ways. Toyota’s Prius appeals to environmentally conscious motorists who wish to help reduce global carbon dioxide emissions. Bentley, Ralph Lauren, Louis Vuitton, Tiffany, Cartier, and Rolex have differentiationbased competitive advantages linked to buyer desires Differentiation can be based on tangible or for status, image, prestige, upscale fashion, superior ­intangible features and attributes. craftsmanship, and the finer things in life. Perceived Value and the Importance of Signaling Value The price premium commanded by a differentiation strategy reflects the value actually delivered to the buyer and the value perceived by the buyer. The value of certain differentiating features is rather easy for buyers to detect, but in some instances, buyers may have trouble assessing what their experience with the product will be. Successful differentiators go to great lengths to make buyers knowledgeable about a product’s value and incorporate signals of value such as attractive packaging, extensive ad campaigns, the quality of brochures and sales presentations, the seller’s list of customers, the length of time the firm has been in business, and the professionalism, appearance, and personality of the seller’s employees. Such signals of value may be as important as actual value (1) when the nature of differentiation is subjective or hard to quantify, (2) when buyers are making a first-time purchase, (3) when repurchase is infrequent, and (4) when buyers are unsophisticated. Concepts & Connections 5.2  describes key elements of BMW’s differentiation strategy that has allowed it to become the number-one luxury automobile brand in the United States. When a Differentiation Strategy Works Best Differentiation strategies tend to work best in market circumstances where: 1. Buyer needs and uses of the product are diverse. Diverse buyer preferences allow industry rivals to set themselves apart with product attributes that appeal to particular buyers. For instance, the diversity of consumer preferences for menu selection, ambience, pricing, and customer service gives restaurants exceptionally wide latitude in creating differentiated concepts. Other industries offering opportunities for differentiation based upon diverse buyer needs and uses include magazine publishing, automobile manufacturing, footwear, kitchen appliances, and computers. 2. There are many ways to differentiate the product or service that have value to buyers. Industries that allow competitors to add features to product attributes are well suited to differentiation strategies. For example, hotel chains can differentiate on such features as location, size of room, range of guest services, in-hotel Chapter 5  The Five Generic Competitive Strategies   101 & Concepts Connections 5.2 HOW BMW’S DIFFERENTIATION STRATEGY ALLOWED IT TO BECOME THE NUMBER-ONE LUXURY CAR BRAND BMW entered the U.S. market for automobiles in 1975 with a model line comprised of the two-door 2002 and 3.0 CSL models and the four-door 530i. The BMW brand was so poorly known in the United States that most Americans assumed that BMW meant “British Motor Works.” The company set about building brand recognition through its BMW Motorsport program that emblazoned “Bavarian Motor Works” across the upper windshields of its 3.0 CSL cars competing in races at Sebring, Laguna Seca, Riverside, and Talladega. BMW’s success on the race track and the instant popularity of its 320i introduced in the United States in 1977 helped build one of the strongest luxury brands in the country by the mid-1980s. The 320i was wildly popular with young professionals, and with each new generation of the 3-series, BMW attracted new young buyers and increased demand for its larger, more expensive models such as the 5-series, 6-series, and 7-series as its repeat buyers moved up in their careers. BMW’s customer value proposition was also keyed to stateof-the-art engineering that resulted in high-performing engines, innovative features, and responsive handling. The company’s “Ultimate Driving Machine” tagline signaled its commitment to sports performance along with luxury. Through the late 2000s, the average pricing for BMW models was at the upper end of the industry, which limited its market share and solidified its reputation as an aspirational luxury brand focused on high-income consumers. However, the introduction of the BMW 1-series in 2008 that carried a sticker price of $28,600 vastly expanded the market for BMWs and allowed the company overtake Lexus as the number-one luxury car brand in the United States that same year. The company also expanded its product line to include a six sedan models, five sports activity vehicle models, seven two-door coupes and convertible models, three hybrid models, the plug-in hybrid i8 sports car, and an all-electric i3 by 2015. The base pricing for BMW’s product line in 2015 ranged from $32,100 for the 2-series coupe to $136,500 for the i8. Sources:; and BMW Magazine, Spring/Summer 2015. dining, and the quality and luxuriousness of bedding and furnishings. Similarly, cosmetics producers are able to differentiate based upon prestige and image, formulations that fight the signs of aging, UV light protection, exclusivity of retail locations, the inclusion of antioxidants and natural ingredients, or prohibitions against animal testing. 3. Few rival firms are following a similar differentiation approach. The best differentiation approaches involve trying to appeal to buyers on the basis of attributes that rivals are not emphasizing. A differentiator encounters less head-to-head rivalry when it goes its own separate way to create uniqueness and does not try to outdifferentiate rivals on the very same attributes. When many rivals are all claiming “ours tastes better than theirs” or “ours gets your clothes cleaner than theirs,” competitors tend to end up chasing the same buyers with very similar product offerings. 4. Technological change is fast-paced and competition revolves around rapidly evolving product features. Rapid product innovation and frequent introductions of next-version products heighten buyer interest and provide space for companies to pursue distinct differentiating paths. In HD TVs, mobile phones, and automobile backup, parking, and lane detection sensors, competitors are locked into an ongoing battle to set themselves apart by introducing the best next-generation products; companies that fail to come up with new and improved products and distinctive performance features quickly lose out in the marketplace. 102  Part 1  Section C: Crafting a Strategy Pitfalls to Avoid in Pursuing a Differentiation Strategy Differentiation strategies can fail for any of several reasons. A differentiation strategy keyed to product or service attributes that are easily and quickly copied is always suspect. Rapid imitation means that no rival achieves meaningful differentiation, because whatever new feature one firm introduces that strikes the fancy of buyers is almost immediately added by rivals. This is why a firm must search out sources of uniqueness that are time-consuming or burdensome for rivals to match if it hopes to use differentiation to win a sustainable competitive edge over rivals. Differentiation strategies can also falter when buyers see little value in the unique attributes of a company’s product. Thus, even if a company sets the attributes of its brand apart from its rivals’ brands, its strategy can fail because of trying to differentiate on the basis of something that does not deliver adequate value to buyers. Any time many potential buyers look at a company’s differentiated product offering and conclude “so what,” the company’s differentiation strategy is in deep trouble; buyers will likely decide the product is not worth the extra price, and sales will be disappointingly low. Overspending on efforts to differentiate is a strategy flaw that can erode profitability. Company efforts to achieve differentiation nearly always raise costs. The trick to profitable differentiation is either to keep the costs of achieving differentiation below the price premium the differentiating attributes can command in the marketplace or to offset thinner profit margins by selling enough additional units to increase total profits. If a company goes overboard in pursuing costly differentiation, it could be saddled with unacceptably thin profit margins or even losses. The need to contain differentiation costs is why many companies add little touches of differentiation that add to buyer satisfaction but are inexpensive to institute. Other common pitfalls and mistakes in crafting a differentiation strategy include: ∙ Overdifferentiating so that product quality or service levels exceed buyers’ needs. Buyers are unlikely to pay extra for features and attributes that will go unused. For example, consumers are unlikely to purchase programmable large appliances such as washers, dryers, and ovens if they are satisfied with manually controlled appliances. ∙ Trying to charge too high a price premium. Even if buyers view certain extras or deluxe features as “nice to have,” they may still conclude that the added benefit or luxury is not worth the price differential over that of lesser differentiated products. ∙ Being timid and not striving to open up meaningful gaps in quality or service or performance features vis-à-vis the products of rivals. Tiny differences between rivals’ product offerings may not be visible or important to buyers. A low-cost provider strategy can always defeat a differentiation strategy when buyers are satisfied with a basic product and don’t think “extra” attributes are worth a higher price. Focused (or Market Niche) Strategies What sets focused strategies apart from low-cost leadership or broad differentiation strategies is a concentration on a narrow piece of the total market. The targeted segment, or niche, can be defined by geographic uniqueness or by special product attributes that appeal only to niche members. The advantages of focusing a company’s Chapter 5  The Five Generic Competitive Strategies   103 entire competitive effort on a single market niche are considerable, especially for smaller and medium-sized companies that may lack the breadth and depth of resources to tackle going after a national customer base with a “something for everyone” lineup of models, styles, and product selection. Lagunitas Brewing Company is a craft brewery with a geographic focus on California, Colorado, Texas, Florida, New York, and Illinois. Lagunitas’ sales of about 250,000 barrels is a small percentage of total U.S. craft beer sales of about 22 million barrels, but it has become the sixth largest craft brewer in the United States and 13th largest U.S. beer producer with annual sales in excess of $100 million. Examples of firms that concentrate on a well-defined market niche keyed to a particular product or buyer segment include Discovery Channel and Comedy Central (in cable TV), Google (in Internet search engines), Porsche (in sports cars), and CGA, Inc. (a specialist in providing insurance to cover the cost of lucrative hole-in-one prizes at golf tournaments).  Local bakeries and cupcake shops, bed-and-breakfast inns, and local owner-managed retail boutiques are all good examples of enterprises that have scaled their operations to serve narrow or local customer segments. A Focused Low-Cost Strategy A focused strategy based on low cost aims at securing a competitive advantage by serving buyers in the target market niche at a lower cost and a lower price than rival competitors. This strategy has considerable attraction when a firm can lower costs significantly by limiting its customer base to a well-defined buyer segment. The avenues to achieving a cost advantage over rivals also serving the target market niche are the same as for low-cost leadership—outmanage rivals in keeping the costs to a bare minimum and searching for innovative ways to bypass or reduce nonessential activities. The only real difference between a low-cost provider strategy and a focused low-cost strategy is the size of the buyer group to which a company is appealing. Focused low-cost strategies are fairly common. Producers of private-label goods are able to achieve low costs in product development, marketing, distribution, and advertising by concentrating on making generic items similar to name-brand merchandise and selling directly to retail chains wanting a low-priced store brand. The Perrigo Company has become a leading manufacturer of over-the-counter health care products with 2014 sales of more than $4.1 billion by focusing on producing private-label brands for retailers such as Walmart, CVS, Walgreens, Rite Aid, and Safeway. Even though ­Perrigo doesn’t make branded products, a focused low-cost strategy is appropriate for the makers of branded products as well. Concepts & Connections 5.3 describes how Aravind’s focus on lowering the costs of cataract removal allowed the company to address the needs of the “bottom of the pyramid” in India’s population where blindness due to cataracts is an endemic problem. A Focused Differentiation Strategy Focused differentiation strategies are keyed to offering carefully designed products or services to appeal to the unique preferences and needs of a narrow, well-defined group of buyers (as opposed to a broad differentiation strategy aimed at many buyer groups and market segments). Companies such as Four Seasons Hotels and Resorts, Chanel, Gucci, and Louis Vuitton employ successful differentiation-based focused strategies 104  Part 1  Section C: Crafting a Strategy & Concepts Connections 5.3 ARAVIND EYE CARE SYSTEM’S FOCUSED LOW-COST STRATEGY Cataracts, the largest cause of preventable blindness, can be treated with a quick surgical procedure that restores sight; however, poverty and limited access to care prevent millions worldwide from obtaining surgery. The Aravind Eye Care System has found a way to address this problem with a focused low-cost strategy that has made cataract surgery not only affordable for more people in India but also free for the very poorest. On the basis of this strategy, Aravind has achieved world renown and become the largest provider of eye care in the world. High volume and high efficiency are at the cornerstone of Aravind’s strategy. The Aravind network of five eye hospitals in India has become one of the most productive systems in the world, conducting about 350,000 surgeries a year in addition to seeing more than 2.8 million outpatients each year. Using the unique model of screenings at camps all over the country, Aravind reaches a broad cross-section of the market for surgical treatment. Additionally, Aravind attains very high staff productivity with each surgeon performing more than 2,500 surgeries annually, compared to 125 for a comparable American surgeon. This level of productivity (with no loss in quality of care) was achieved through the development of a standardized system of surgical treatment, capitalizing on the fact that cataract removal is a fairly routine process. Aravind streamlined as much of the process as possible, reducing discretionary elements to a minimum and tracking outcomes to ensure continuous process improvement. At Aravind’s hospitals, no time is wasted between surgeries as different teams of support staff prepare patients for surgery and bring them to the operating theater; surgeons simply turn from one table to another to perform surgery on the next prepared patient. Aravind also drove costs down through the creation of its own manufacturing division, Aurolab, to produce intraocular lenses, suture needles, pharmaceuticals, and surgical blades in India. Aravind’s low costs allow it to keep prices for cataract surgery very low—about $10 per patient, compared to an average cost of $1,500 in the United States. Nevertheless, the system provides surgical outcomes and quality comparable to those of clinics in the United States. As a result of its unique fee system and effective management, Aravind is also able to provide free eye care to 60 percent of its patients from the revenue generated from paying patients. Sources: Developed with Avni V. Patel. G. Natchiar, A. L. Robin, R. Thulasiraj, et al., “Attacking the Backlog of India’s Curable Blind; The Aravind Eye Hospital Model,” Archives of Ophthalmology 112, no. 7 (July 1994), pp. 987–93; D. F. Chang, “Tackling the Greatest Challenge in Cataract Surgery,” British Journal of Ophthalmology 89, no. 9 (September 2005), pp. 1073–77; and McKinsey & Co., “Driving Down the Cost of High-Quality Care,” Health International, ­December 2011. targeted at affluent buyers wanting products and services with world-class attributes. Indeed, most markets contain a buyer segment willing to pay a price premium for the very finest items available, thus opening the strategic window for some competitors to pursue differentiation-based focused strategies aimed at the very top of the market pyramid. Another successful focused differentiator is “fashion food retailer” Trader Joe’s, a 457-store, 42-state chain that is a combination gourmet deli and food warehouse. Customers shop Trader Joe’s as much for entertainment as for conventional grocery items; the store stocks out-of-the-ordinary culinary treats such as raspberry salsa, salmon burgers, and jasmine fried rice, as well as the standard goods normally found in supermarkets. What sets Trader Joe’s apart is not just its unique combination of food novelties and competitively priced grocery items but also its capability to turn an otherwise mundane grocery excursion into a whimsical treasure hunt that is just plain fun. Chapter 5  The Five Generic Competitive Strategies   105 When a Focused Low-Cost or Focused Differentiation Strategy Is Viable A focused strategy aimed at securing a competitive edge based on either low cost or differentiation becomes increasingly attractive as more of the following conditions are met: ∙ The target market niche is big enough to be profitable and offers good growth potential. ∙ Industry leaders have chosen not to compete in the niche—focusers can avoid battling head-to-head against the industry’s biggest and strongest competitors. ∙ It is costly or difficult for multisegment competitors to meet the specialized needs of niche buyers and at the same time satisfy the expectations of mainstream customers. ∙ The industry has many different niches and segments, thereby allowing a focuser to pick a niche suited to its resource strengths and capabilities. ∙ Few, if any, rivals are attempting to specialize in the same target segment. The Risks of a Focused Low-Cost or Focused Differentiation Strategy Focusing carries several risks. The first major risk is the chance that competitors will find effective ways to match the focused firm’s capabilities in serving the target niche. In the lodging business, large chains such as Marriott and Hilton have launched multibrand strategies that allow them to compete effectively in several lodging segments simultaneously. Marriott has flagship hotels with a full complement of services and amenities that allow it to attract travelers and vacationers going to major resorts; it has J.W. Marriott, Ritz-Carlton, and Renaissance hotels that provide deluxe comfort and service to business and leisure travelers; it has Courtyard by Marriott and SpringHill Suites brands for business travelers looking for moderately priced lodging; it has Marriott Residence Inns and TownePlace Suites designed as a “home away from home” for travelers staying five or more nights; and it has more than 700 Fairfield Inn locations that cater to travelers looking for quality lodging at an “affordable” price. Marriott has also added Edition, AC Hotels by Marriott, and Autograph Collection hotels that offer stylish, distinctive decors and personalized services that appeal to young professionals seeking distinctive lodging alternatives. Multibrand strategies are attractive to large companies such as Marriott precisely because they enable a company to enter a market niche and siphon business away from companies that employ a focus strategy. A second risk of employing a focus strategy is the potential for the preferences and needs of niche members to shift over time toward the product attributes desired by the majority of buyers. An erosion of the differences across buyer segments lowers entry barriers into a focuser’s market niche and provides an open invitation for rivals in adjacent segments to begin competing for the focuser’s customers. A third risk is that the segment may become so attractive it is soon inundated with competitors, intensifying rivalry and splintering segment profits. 106  Part 1  Section C: Crafting a Strategy LO4   Recognize the required conditions for delivering superior value to customers through the use of a hybrid of low-cost provider and differentiation strategies. Best-Cost Provider Strategies As Figure 5.1 indicates, best-cost provider strategies are a hybrid of low-cost provider and differentiation strategies that aim at satisfying buyer expectations on key quality/features/performance/service attributes and beating customer expectations on price. Companies pursuing best-cost strategies aim squarely at the sometimes great mass of value-conscious buyers looking for a good-to-very-good product or service at an economical price. The essence of a best-cost provider strategy is giving customers more value for the CORE CONCEPT money by satisfying buyer desires for appealing feaBest-cost provider strategies are a hybrid of tures/performance/quality/service and charging a lower low-cost provider and differentiation ­strategies price for these attributes compared to that of rivals with that aim at satisfying buyer expectations on similar-caliber product offerings.3 key quality/features/performance/ service To profitably employ a best-cost provider strategy, ­attributes and beating customer expectations a company must have the capability to incorporate on price. attractive or upscale attributes at a lower cost than rivals. This capability is contingent on (1) a superior value chain configuration that eliminates or minimizes activities that do not add value, (2) unmatched efficiency in managing essential value chain activities, and (3) core competencies that allow differentiating attributes to be incorporated at a low cost. When a company can incorporate appealing features, good-to-excellent product performance or quality, or more satisfying customer service into its product offering at a lower cost than that of rivals, then it enjoys “best-cost” status—it is the low-cost provider of a product or service with upscale attributes. A best-cost provider can use its low-cost advantage to underprice rivals whose products or services have similar upscale attributes and still earn attractive profits. Concepts & Connections 5.4 describes how American Giant has applied the principles of a best-cost provider strategy in producing and marketing its hoodie sweatshirts. When a Best-Cost Provider Strategy Works Best A best-cost provider strategy works best in markets where product differentiation is the norm and attractively large numbers of value-conscious buyers can be induced to purchase midrange products rather than the basic products of low-cost producers or the expensive products of top-of-the-line differentiators. A best-cost provider usually needs to position itself near the middle of the market with either a medium-quality product at a below-average price or a high-quality product at an average or slightly higherthan-average price. Best-cost provider strategies also work well in recessionary times when great masses of buyers become value-conscious and are attracted to economically priced products and services with especially appealing attributes. The Danger of an Unsound Best-Cost Provider Strategy A company’s biggest vulnerability in employing a best-cost provider strategy is not having the requisite core competencies and efficiencies in managing value chain activities to support the addition of differentiating features without significantly increasing costs. A company with a modest degree of differentiation and no real cost advantage will most likely find itself squeezed between the firms using low-cost strategies and those using differentiation strategies. Low-cost providers may be able to siphon customers away with the appeal of a lower price (despite having marginally less appealing Chapter 5  The Five Generic Competitive Strategies   107 & Concepts Connections 5.4 AMERICAN GIANT’S BEST-COST PROVIDER STRATEGY Bayard Winthrop, founder and owner of American Giant, set out to make a hoodie like the soft, ultra-thick Navy sweatshirts his dad used to wear in the 1950s. But he also had two other aims: He wanted it to have a more updated look with a tailored fit, and he wanted it produced cost-effectively so that it could be sold at a great price. To accomplish these aims, he designed the sweatshirt with the help of a former industrial engineer from Apple and an internationally renowned pattern maker, rethinking every aspect of sweatshirt design and production along the way. The result was a hoodie differentiated from others on the basis of extreme attention to fabric, fit, construction, and durability. The hoodie is made from heavy-duty cotton that is run through a machine that carefully picks loops of thread out of the fabric to create a thick, combed, ring-spun fleece fabric that feels three times thicker than most sweatshirts. A small amount of spandex paneling along the shoulders and sides creates the fitted look and maintains the shape, keeping the sweatshirt from looking slouchy or sloppy. It has double stitching with strong thread on critical seams to avoid deterioration and boost durability. The zippers and draw cord are customized to match the sweatshirt’s color—an uncommon practice in the business. American Giant sources yarn from Parkdale, South Carolina, and turns it into cloth at the nearby Carolina Cotton Works. This reduces transport costs, creates a more dependable, durable product that American Giant can easily quality-check, and shortens product turnaround to about a month, lowering inventory costs. This process also enables the company to use a genuine “Made in the U.S.A” label, a perceived quality driver. American Giant disrupts the traditional, expensive distribution models by having no stores or resellers. Instead, it sells directly to customers from its website, with free two-day shipping and returns. Much of the company’s growth comes from word of mouth and a strong public relations effort that promotes the brand in magazines, newspapers, and key business-oriented television programs. American Giant has a robust refer-a-friend program that offers a discount to friends of, and a credit to, current owners. Articles in popular media proclaiming its product “the greatest hoodie ever made” have made demand for its sweatshirts skyrocket. At $79 for the original men’s hoodie, American Giant is not cheap but offers customers value in terms of both price and quality. The price is higher than what one would pay at The Gap or American Apparel and comparable to Levi’s, J.Crew, or Banana Republic. But its quality is more on par with high-priced designer brands, while its price is far more affordable. Note: Developed with Sarah Boole. Sources:;;; product attributes). High-end differentiators may be able to steal customers away with the appeal of appreciably better product attributes (even though their products carry a somewhat higher price tag). Thus, a successful best-cost provider must offer buyers significantly better product attributes to justify a price above what low-cost leaders are charging. Likewise, it has to achieve significantly lower costs in providing upscale features so that it can outcompete high-end differentiators on the basis of a significantly lower price. 108  Part 1  Section C: Crafting a Strategy Successful Competitive Strategies Are Resource Based For a company’s competitive strategy to succeed in delivering good performance and the intended competitive edge over rivals, it has to be well matched to a company’s internal situation and underpinned by an appropriate set of resources, know-how, and competitive capabilities. To succeed in employing a low-cost provider strategy, a company has to have the resources and capabilities to keep its costs below those of its competitors; this means having the expertise to cost-effectively manage value chain activities better than rivals and/or the innovative capability to bypass certain value chain activities being performed by rivals. To succeed in strongly differentiating its product in ways that are appealing to buyers, a company must have the resources and capabilities (such as better technology, strong skills in product innovation, expertise in customer service) to incorporate unique attributes into its product offering that a broad range of buyers will find appealing and worth paying for. Strategies focusing on a narrow segment of the market require the capability to do an outstanding job of satisfying the needs and expectaA company’s competitive strategy should be well tions of niche buyers. Success in employing a strategy matched to its internal situation and predicated on keyed to a best-value offering requires the resources leveraging its collection of competitively valuable and capabilities to incorporate upscale product or serresources and competencies. vice attributes at a lower cost than that of rivals. KEY POINTS 1. Early in the process of crafting a strategy, company managers have to decide which of the five basic competitive strategies to employ: overall low-cost, broad differentiation, focused low-cost, focused differentiation, or best-cost provider. 2. In employing a low-cost provider strategy, a company must do a better job than rivals of cost-effectively managing internal activities, and/or it must find innovative ways to eliminate or bypass cost-producing activities. Particular attention should be paid to cost drivers, which are factors having a strong effect on the cost of a company’s value chain activities and cost structure. Low-cost provider strategies work particularly well when price competition is strong and the products of rival sellers are very weakly differentiated. Other conditions favoring a low-cost provider strategy are when supplies are readily available from eager sellers, when there are not many ways to differentiate that have value to buyers, when the majority of industry sales are made to a few large buyers, when buyer switching costs are low, and when industry newcomers are likely to use a low introductory price to build market share. 3. Broad differentiation strategies seek to produce a competitive edge by incorporating attributes and features that set a company’s product/service offering apart from rivals in ways that buyers consider valuable and worth paying for. Such features and attributes are best integrated through the systematic management of uniqueness—value chain activities or factors that can have a strong effect on customer value and creating differentiation. Successful differentiation allows a firm to (1) command a premium price for its product, (2) increase unit sales (because additional buyers are won over by the differentiating features), and/or (3) gain buyer loyalty to its brand (because some buyers are strongly attracted to the differentiating features and bond with the company and its products). Differentiation strategies work best in markets with diverse buyer preferences where there are big windows of opportunity to strongly differentiate a company’s product offering from those of rival brands, in situations where few other rivals are pursuing a similar differentiation approach, and in circumstances where technological change is fast-paced and competition centers on rapidly evolving product features. A differentiation strategy is doomed when competitors are able to quickly copy most or all of the appealing product attributes a company comes up with, when a company’s differentiation efforts meet with a ho-hum or sowhat market reception, or when a company erodes profitability by overspending on efforts to differentiate its product offering. 4. A focused strategy delivers competitive advantage either by achieving lower costs than rivals’ in serving buyers comprising the target market niche or by offering niche buyers an appealingly differentiated product or service that meets their needs better than rival brands. A focused strategy becomes increasingly attractive when the target market niche is big enough to be profitable and offers good growth potential, when it is costly or difficult for multisegment competitors to put capabilities in place to meet the specialized needs of the target market niche and at the same time satisfy the expectations of their mainstream customers, when there are one or more niches that present a good match with a focuser’s resource strengths and capabilities, and when few other rivals are attempting to specialize in the same target segment. 5. Best-cost provider strategies stake out a middle ground between pursuing a low-cost advantage and a differentiation-based advantage and between appealing to the broad market as a whole and a narrow market niche. The aim is to create competitive advantage by giving buyers more value for the money—satisfying buyer expectations on key quality/ features/performance/service attributes while beating customer expectations on price. To profitably employ a best-cost provider strategy, a company must have the capability to incorporate attractive or upscale attributes at a lower cost than that of rivals. This capability is contingent on (1) a superior value chain configuration, (2) unmatched efficiency in managing essential value chain activities, and (3) resource strengths and core competencies that allow differentiating attributes to be incorporated at a low cost. A bestcost provider strategy works best in markets where opportunities to differentiate exist and where many buyers are sensitive to price and value. 6. Deciding which generic strategy to employ is perhaps the most important strategic commitment a company makes—it tends to drive the rest of the strategic actions a company decides to undertake, and it sets the whole tone for the pursuit of a competitive advantage over rivals. ASSURANCE OF LEARNING EXERCISES 1. Best Buy is the largest consumer electronics retailer in the United States with 2015 sales of more than $40 billion. The company competes aggressively on price with rivals such as Costco Wholesale, Sam’s Club, Walmart, and Target but is also known by consumers for its first-rate customer service. Best Buy customers have commented that the retailer’s sales staff is exceptionally knowledgeable about products and can direct them to the exact location of difficult-to-find items. Best Buy customers also appreciate that demonstration models of PC monitors, digital media players, and other electronics are fully powered and ready for in-store use. Best Buy’s Geek Squad tech support and installation services are additional customer service features valued by many customers. LO1, LO2, LO3, LO4 109 How would you characterize Best Buy’s competitive strategy?  Should it be classified as a low-cost provider strategy? A differentiation strategy? A best-cost strategy? Explain your answer. 2. LO2 LO1, LO2, LO3, LO4 LO3 Concepts & Connections 5.1 discusses Walmart’s low-cost advantage in the supermarket industry. Based on information provided in the illustration, explain how Walmart has built its low-cost advantage in the supermarket industry and why a low-cost provider strategy is well suited to the industry. 3. USAA is a Fortune 500 insurance and financial services company with 2014 annual sales exceeding $24 billion. The company was founded in 1922 by 25 Army officers who decided to insure each other’s vehicles and continues to limit its membership to activeduty and retired military members, officer candidates, and adult children and spouses of military-affiliated USAA members. The company has received countless awards, including being listed among Fortune’s World’s Most Admired Companies in 2014 and 2015 and 100 Best Companies to Work For in 2010 through 2015. USAA was also ranked as the number-one Bank, Credit Card and Insurance Company by Forrester Research from 2013 to 2015. You can read more about the company’s history and strategy at How would you characterize USAA’s competitive strategy? Should it be classified as a low-cost provider strategy? A differentiation strategy? A best-cost strategy? Also, has the company chosen to focus on a narrow piece of the market, or does it appear to pursue a broad market approach? Explain your answer. 4 . Explore lululemon athletica’s website at and see if you can identify at least three ways in which the company seeks to differentiate itself from rival athletic apparel firms. Is there reason to believe that lululemon’s differentiation strategy has been successful in producing a competitive advantage? Why or why not? EXERCISES FOR SIMULATION PARTICIPANTS LO1, LO2, LO3, LO4 1. 2 . 3. 4. 5. 6. Which one of the five generic competitive strategies best characterizes your company’s strategic approach to competing successfully? Which rival companies appear to be employing a low-cost provider strategy? Which rival companies appear to be employing a broad differentiation strategy? Which rival companies appear to be employing a best-cost provider strategy? Which rival companies appear to be employing some type of focus strategy? What is your company’s action plan to achieve a sustainable competitive advantage over rival companies? List at least three (preferably, more than three) specific kinds of decision entries on specific decision screens that your company has made or intends to make to win this kind of competitive edge over rivals. ENDNOTES 1. Michael E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press, 1980), chap. 2, and Michael E. Porter, “What Is Strategy?” Harvard 110 Business Review 74, no. 6 (November– December 1996). 2. Michael E. Porter, Competitive Advantage (New York: Free Press, 1985). 3. Peter J. Williamson and Ming Zeng, “Value-for-Money Strategies for Recessionary Times,” Harvard Business Review 87, no. 3 (March 2009). Strengthening a Company’s Competitive Position: Strategic Moves, Timing, and Scope of Operations chapter 6 LEARNING OBJECTIVES LO1 Learn whether and when to pursue offensive or defensive strategic moves to improve a company’s market position. LO2 Recognize when being a first mover or a fast follower or a late mover can lead to competitive advantage. LO3 Become aware of the strategic benefits and risks of expanding a company’s horizontal scope through mergers and acquisitions. LO4 Learn the advantages and disadvantages of extending a company’s scope of operations via vertical integration. LO5 Understand the conditions that favor farming out certain value chain activities to outside parties. LO6 Gain an understanding of how strategic alliances and collaborative partnerships can bolster a company’s collection of resources and capabilities. 111 112  Part 1  Section C: Crafting a Strategy Once a company has settled on which of the five generic competitive strategies to employ, attention turns to what other strategic actions it can take to complement its competitive approach and maximize the power of its overall strategy. Several decisions regarding the company’s operating scope and how to best strengthen its market standing must be made: ∙ Whether and when to go on the offensive and initiate aggressive strategic moves to improve the company’s market position ∙ Whether and when to employ defensive strategies to protect the company’s market position ∙ When to undertake strategic moves based upon whether it is advantageous to be a first mover or a fast follower or a late mover ∙ Whether to integrate backward or forward into more stages of the industry value chain ∙ Which value chain activities, if any, should be outsourced ∙ Whether to enter into strategic alliances or partnership arrangements with other enterprises ∙ Whether to bolster the company’s market position by merging with or acquiring another company in the same industry This chapter presents the pros and cons of each of these measures that round out a company’s overall strategy. LO1   Learn whether and when to pursue offensive or defensive strategic moves to improve a company’s market position. Launching Strategic Offensives to Improve a Company’s Market Position No matter which of the five generic competitive strategies a company employs, there are times when a company should be aggressive and go on the offensive. Strategic offensives are called for when a company spots opportunities to gain profitable market share at the expense of rivals or when a company has no choice but to try to whittle away at a strong rival’s competitive advantage. Companies such as Samsung, Amazon, Autonation, and Google play hardball, aggressively pursuing competitive advantage and trying to reap the benefits a competitive edge offers—a leading market share, excellent profit margins, and rapid growth.1 Choosing the Basis for Competitive Attack Generally, strategic offensives should be grounded in a company’s competitive assets and strong points and should be aimed at exploiting competitor weaknesses.2 Ignoring the need to tie a strategic offensive to a company’s competitive strengths is like going to war with a popgun—the prospects for success are dim. For instance, it is foolish for a company with relatively high costs to employ a price-cutting offensive. Likewise, it is ill advised to The best offensives use a company’s most compursue a product innovation offensive without having petitively potent resources to attack rivals in those proven expertise in R&D, new-product development, competitive areas where they are weakest. and speeding new or improved products to market. Chapter 6  Strengthening a Company’s Competitive Position   113 The principal offensive strategy options include: 1. Offering an equally good or better product at a lower price. Lower prices can produce market share gains if competitors offering similarly performing products don’t respond with price cuts of their own. Price-cutting offensives are best initiated by companies that have first achieved a cost advantage.3 2. Leapfrogging competitors by being the first to market with next-generation technology or products. Microsoft got its next-generation Xbox 360 to market 12 months ahead of Sony’s PlayStation 3 and Nintendo’s Wii, helping it build a sizable market share and develop a reputation for cutting-edge innovation in the video game industry. 3. Pursuing continuous product innovation to draw sales and market share away from less innovative rivals. Ongoing introductions of new or improved products can put rivals under tremendous competitive pressure, especially when rivals’ new-product development capabilities are weak. 4. Pursuing disruptive product innovations to create new markets. While this strategy can be riskier and more costly than a strategy of continuous innovation, it can be a game changer if successful. Disruptive innovation involves perfecting new products or services that offer an altogether new and better value proposition. Examples include Facebook, Tumblr, Twitter,, Square (mobile credit card processing), and Amazon’s Kindle. 5. Adopting and improving on the good ideas of other companies (rivals or otherwise). The idea of warehouse-type home improvement centers did not originate with Home Depot co-founders Arthur Blank and Bernie Marcus; they got the “big box” concept from their former employer, Handy Dan Home Improvement. But they were quick to improve on Handy Dan’s business model and strategy and take Home Depot to a higher plateau in terms of product-line breadth and customer service. 6. Using hit-and-run or guerrilla warfare tactics to grab sales and market share from complacent or distracted rivals. Options for “guerrilla offensives” include occasional lowballing on price (to win a big order or steal a key account from a rival) or surprising key rivals with sporadic but intense bursts of promotional activity (offering a 20 percent discount for one week to draw customers away from rival brands).4 Guerrilla offensives are particularly well suited to small challengers who have neither the resources nor the market visibility to mount a fullfledged attack on industry leaders. 7. Launching a preemptive strike to capture a rare opportunity or secure an industry’s limited resources.5 What makes a move preemptive is its one-of-a-kind nature—whoever strikes first stands to acquire competitive assets that rivals can’t readily match. Examples of preemptive moves include (1) securing the best distributors in a particular geographic region or country; (2) moving to obtain the most favorable site at a new interchange or intersection, in a new shopping mall, and so on; and (3) tying up the most reliable, high-quality suppliers via exclusive partnerships, long-term contracts, or even acquisition. To be successful, a preemptive move doesn’t have to totally block rivals from following or copying; it merely needs to give a firm a prime position that is not easily circumvented. 114  Part 1  Section C: Crafting a Strategy Choosing Which Rivals to Attack Offensive-minded firms need to analyze which of their rivals to challenge as well as how to mount that challenge. The best targets for offensive attacks are: ∙ Market leaders that are vulnerable. Offensive attacks make good sense when a company that leads in terms of size and market share is not a true leader in terms of serving the market well. Signs of leader vulnerability include unhappy buyers, an inferior product line, a weak competitive strategy with regard to low-cost leadership or differentiation, a preoccupation with diversification into other industries, and mediocre or declining profitability. ∙ Runner-up firms with weaknesses in areas where the challenger is strong. Runner-up firms are an especially attractive target when a challenger’s resource strengths and competitive capabilities are well suited to exploiting their weaknesses. ∙ Struggling enterprises that are on the verge of going under. Challenging a hardpressed rival in ways that further sap its financial strength and competitive position can hasten its exit from the market. ∙ Small local and regional firms with limited capabilities. Because small firms typically have limited expertise and resources, a challenger with broader capabilities is well positioned to raid their biggest and best customers. Blue Ocean Strategy—A Special Kind of Offensive A blue ocean strategy seeks to gain a dramatic and durable competitive advantage by abandoning efforts to beat out competitors in existing markets and, instead, inventing a new industry or distinctive market segment that renders existing competitors largely irrelevant and allows a company to create and capture altogether new demand.6 This strategy views the business universe as consisting of two distinct types of market space. One is where industry boundaries are defined and accepted, the competitive rules of the game are well understood by all industry members, and companies try to outperform rivals by capturing a bigger share of existing demand; in such markets, lively competition constrains a company’s prospects for rapid growth and superior profitability since rivals move quickly to either imitate or counter the successes of competitors. The second type of market space is a “blue ocean” where the industry does not really exist yet, is untainted by competition, and offers wide-open opportunity for profitable and rapid growth if a company can come up with a product offering and strategy that allows it CORE CONCEPT to create new demand rather than fight over existing Blue ocean strategies offer growth in revenues demand. A terrific example of such wide-open or blue and profits by discovering or inventing new indusocean market space is the online auction industry that try segments that create altogether new demand. eBay created and now dominates. Other examples of companies that have achieved competitive advantages by creating blue ocean market spaces include Starbucks in the coffee shop industry, Amazon’s Kindle in eBooks, FedEx in overnight package delivery, Uber in ride sharing services, and Cirque du Soleil in live entertainment. Cirque du Soleil “reinvented the circus” by creating a distinctively different market space for its performances (Las Vegas nightclubs and theater-type settings) and pulling in a whole new group of customers—adults Chapter 6  Strengthening a Company’s Competitive Position   115 and corporate clients—who were willing to pay several times more than the price of a conventional circus ticket to have an “entertainment experience” featuring sophisticated clowns and star-quality acrobatic acts in a comfortable atmosphere. Blue ocean strategies provide a company with a great opportunity in the short run. But they don’t guarantee a company’s long-term success, which depends more on whether a company can protect the market position it opened up. Concepts & Connections 6.1 discusses how Gilt Groupe used a blue ocean strategy to open a new competitive space in online luxury retailing. Using Defensive Strategies to Protect a Company’s Market Position and Competitive Advantage In a competitive market, all firms are subject to offensive challenges from rivals. The purposes of defensive strategies are to lower the risk of being attacked, weaken the impact of any attack that occurs, and influence challengers to aim their efforts at other rivals. While defensive strategies usually don’t enhance a firm’s competitive advantage, they can definitely help fortify its Good defensive strategies can help protect comcompetitive position. Defensive strategies can take petitive advantage but rarely are the basis for either of two forms: actions to block challengers and creating it. actions signaling the likelihood of strong retaliation. Blocking the Avenues Open to Challengers The most frequently employed approach to defending a company’s present position involves actions to restrict a competitive attack by a challenger. A number of obstacles can be put in the path of would-be challengers.7 A defender can introduce new features, add new models, or broaden its product line to close vacant niches to opportunity-seeking challengers. It can thwart the efforts of rivals to attack with a lower price by maintaining economy-priced options of its own. It can try to discourage buyers from trying competitors’ brands by making early announcements about upcoming new products or planned price changes. Finally, a defender can grant volume discounts or better financing terms to dealers and distributors to discourage them from experimenting with other suppliers. Signaling Challengers That Retaliation Is Likely The goal of signaling challengers that strong retaliation is likely in the event of an attack is either to dissuade challengers from attacking or to divert them to less threatening options. Either goal can be achieved by letting challengers know the battle will cost more than it is worth. Would-be challengers can be signaled by: ∙ Publicly announcing management’s commitment to maintain the firm’s present market share. ∙ Publicly committing the company to a policy of matching competitors’ terms or prices. ∙ Maintaining a war chest of cash and marketable securities. ∙ Making an occasional strong counterresponse to the moves of weak competitors to enhance the firm’s image as a tough defender. 116  Part 1  Section C: Crafting a Strategy & Concepts Connections 6.1 GILT GROUPE’S BLUE OCEAN STRATEGY IN THE U.S. FLASH SALE INDUSTRY Luxury fashion flash sales exploded onto the U.S. e-commerce scene when Gilt Groupe launched its business in 2007. Flash sales offer limited quantities of high-end designer brands at steep discounts to site members over a very narrow time frame: The opportunity to snap up an incredible bargain is over in a “flash.” The concept of online time-limited, designer-brand sale events, available to members only, had been invented six years earlier by the French company Vente Privée. But since Vente Privée operated in Europe and the United Kingdom, the U.S. market represented a wide-open, blue ocean of uncontested opportunity. Gilt Groupe’s only rival was Ideeli, another U.S. start-up that had launched in the same year. Gilt Groupe grew rapidly in the calm waters of the early days of the U.S. industry. Its tremendous growth stemmed from its recognition of an underserved segment of the population—the web-savvy, value-conscious fashionista—and also from fortuitous timing. The Great Recession hit the United States in December 2007, causing a sharp decline in consumer buying and leaving designers with unforeseen quantities of luxury items they could not sell. The fledgling flash sale industry was the perfect channel to off-load excess inventory, while it still maintained the cachet of exclusivity through members-only sales and limited-time availability. Gilt’s revenue grew exponentially from $25 million in 2008 to upward of $700 million by 2012. But the company’s success prompted an influx of fast followers into the luxury flash sale industry, including HauteLook and Rue La La, which entered the market in December 2007 and April 2008, respectively. Competition among rival sites became especially strong since memberships were free and online customers could switch easily from site to site. Competition also heightened as larger retailers entered the luxury flash sale industry, with Nordstrom acquiring HauteLook, eBay purchasing Rue La La, and Amazon acquiring In late 2011, Vente Privée announced the launch of its U.S. online site, via a joint venture with American Express. As the competitive waters roiled and turned increasingly red, Gilt Groupe began looking for new ways to compete, expanding into a variety of online luxury product and services niches and venturing overseas. While the company is not yet profitable, its operating performance has improved, and it attracted an additional $50 million in investor funding in 2015. The flash sale site has received more than $300 million in angel investments and venture capital since its launch in 2007.  Can Gilt Groupe survive in a more crowded competitive space and provide its investors with a strong return? Only time will tell. Developed with Judith H. Lin. Sources: Matthew Carroll, “The Rise of Gilt Groupe,”, January 2012, (accessed February 26, 2012); Mark “Launching Gilt Groupe, A Fashionable Enterprise,” Wall Street Journal, October 2010, (accessed February 26, 2012);, accessed March 3, 2012. LO2   Recognize when being a first mover or a fast follower or a late mover can lead to competitive advantage. Timing a Company’s Offensive and Defensive Strategic Moves When to make a strategic move is often as crucial as what move to make. Timing is especially important when first-mover advantages or disadvantages exist. Being first to initiate a strategic move can have a high payoff when (1) pioneering helps build a firm’s image and reputation with buyers; (2) early commitments to new technologies, new-style components, new or emerging distribution channels, and so on can produce an absolute cost advantage over rivals; CORE CONCEPT (3) first-time customers remain strongly loyal to pioneerBecause of first-mover advantages and ing firms in making repeat purchases; and (4) moving first ­ isadvantages, competitive advantage can spring d constitutes a preemptive strike, making imitation extra from when a move is made as well as from what hard or unlikely. The bigger the first-mover advantages, move is made. the more attractive making the first move becomes.8 Chapter 6  Strengthening a Company’s Competitive Position   117 Sometimes, though, markets are slow to accept the innovative product offering of a first mover, in which case a fast follower with substantial resources and marketing muscle can overtake a first mover. CNN had enjoyed a powerful first mover advantage in cable news until 2002, when it was surpassed by Fox News as the number-one cable news network. Fox has used innovative programming and intriguing hosts to expand its demographic appeal to retain its number-one ranking for 15 consecutive years. Sometimes furious technological change or product innovation makes a first mover vulnerable to quickly appearing next-generation technology or products. For instance, former market leaders in mobile phones Nokia and BlackBerry have been victimized by far more innovative iPhone and Android models. Hence, there are no guarantees that a first mover will win sustainable competitive advantage.9 To sustain any advantage that may initially accrue to a pioneer, a first mover needs to be a fast learner and continue to move aggressively to capitalize on any initial pioneering advantage. If a first mover’s skills, know-how, and actions are easily copied or even surpassed, then followers and even late movers can catch or overtake the first mover in a relatively short period. What makes being a first mover strategically important is not being the first company to do something but rather being the first competitor to put together the precise combination of features, customer value, and sound revenue/cost/profit economics that gives it an edge over rivals in the battle for market leadership.10 If the marketplace quickly takes to a first mover’s innovative product offering, a first mover must have large-scale production, marketing, and distribution capabilities if it is to stave off fast followers that possess similar resources capabilities. If technology is advancing at a torrid pace, a first mover cannot hope to sustain its lead without having strong capabilities in R&D, design, and new-product development, along with the financial strength to fund these activities. The Potential for Late-Mover Advantages or First-Mover Disadvantages There are instances when there are actually advantages to being an adept follower rather than a first mover. Late-mover advantages (or first-mover disadvantages) arise in four instances: ∙ When pioneering leadership is more costly than followership and only negligible experience or learning curve benefits accrue to the leader—a condition that allows a follower to end up with lower costs than the first mover. ∙ When the products of an innovator are somewhat primitive and do not live up to buyer expectations, thus allowing a clever follower to win disenchanted buyers away from the leader with better-performing products. ∙ When potential buyers are skeptical about the benefits of a new technology or product being pioneered by a first mover. ∙ When rapid market evolution (due to fast-paced changes in either technology or buyer needs and expectations) gives fast followers and maybe even cautious late movers the opening to leapfrog a first mover’s products with more attractive nextversion products. Concepts & Connections 6.2 describes how achieved a first-mover advantage in online retailing. 118  Part 1  Section C: Crafting a Strategy Deciding Whether to Be an Early Mover or Late Mover In weighing the pros and cons of being a first mover versus a fast follower versus a slow mover, it matters whether the race to market leadership in a particular industry is a marathon or a sprint. In marathons, a slow mover is not unduly penalized—first-mover advantages can be fleeting, and there’s ample time for fast followers and sometimes even late movers to catch up.11 Thus the speed at which the pioneering innovation is likely to catch on matters considerably as companies struggle with whether to pursue a particular emerging market opportunity aggressively or cautiously. For instance, it took 5.5 years for worldwide mobile phone use to grow from 10 million to 100 million worldwide and close to 10 years for the number of at-home broadband subscribers to grow to 100 million worldwide. The lesson here is that there is a market-penetration curve for every emerging opportunity; typically, the curve has an inflection point at which all the pieces of the business model fall into place, buyer demand explodes, and the market takes off. The inflection point can come early on a fast-rising curve (as with the use of e-mail) or farther on up a slow-rising curve (such as the use of broadband). Any company that seeks competitive advantage by being a first mover thus needs to ask some hard questions: ∙ Does market takeoff depend on the development of complementary products or services that currently are not available? ∙ Is new infrastructure required before buyer demand can surge? ∙ Will buyers need to learn new skills or adopt new behaviors? Will buyers encounter high switching costs? ∙ Are there influential competitors in a position to delay or derail the efforts of a first mover? When the answers to any of these questions are yes, then a company must be careful not to pour too many resources into getting ahead of the market opportunity—the race is likely going to be more of a 10-year marathon than a 2-year sprint. Strengthening a Company’s Market Position via Its Scope of Operations Apart from considerations of offensive and defensive competitive moves and their timing, another set of managerial decisions can affect the strength of a company’s market position. These decisions concern the scope of the firm—the breadth of a company’s activities and the extent of its market reach. For example, Ralph Lauren Corporation designs, markets, and distributes fashionable apparel and other merchandise to more than 10,000 major department stores and specialty retailers around the world, plus it also operates nearly 400 Ralph Lauren retail stores, 200-plus factory stores, and seven e-commerce sites. CORE CONCEPT Scope decisions also concern which segments of the The scope of the firm refers to the range of market to serve—decisions that can include geographic activities the firm performs internally, the breadth market segments as well as product and service segof its product and service offerings, the extent of ments. Almost 40 percent of Ralph Lauren’s sales its geographic market presence, and its mix of are made outside the United States, and its product businesses. line includes apparel, fragrances, home furnishings, Chapter 6  Strengthening a Company’s Competitive Position   119 eyewear, watches and jewelry, and handbags and other CORE CONCEPT leather goods. The company has also expanded its Horizontal scope is the range of product and brand lineup through the acquisitions of Chaps mensservice segments that a firm serves within its focal wear and casual retailer Club Monaco. market. Four dimensions of firm scope have the capacity to strengthen a company’s position in a given market: the breadth of its product and service offerings, the range of activities the firm performs internally, the extent of its geographic market presence, and its mix of businesses. In this chapter, we discuss horizontal and vertical scope decisions in relation to its breadth of offerings and range of internally performed activities. A company’s horizontal scope, which is the range of product and service segments that it serves, can be expanded through new-business development or mergers and acquisitions of other companies in the marketplace. The company’s vertical scope is the extent to which it engages in the CORE CONCEPT various activities that make up the industry’s entire Vertical scope is the extent to which a firm’s intervalue chain system—from raw-material or component nal activities encompass one, some, many, or all production all the way to retailing and after-sales serof the activities that make up an industry’s entire vice. Expanding a company’s vertical scope by means value chain system, ranging from raw-material production to final sales and service activities. of vertical integration can also affect the strength of a company’s market position. Additional dimensions of a firm’s scope are discussed in Chapter 7, which focuses on the company’s geographic scope and expansion into foreign markets, and Chapter 8, which takes up the topic of business diversification and corporate strategy. Horizontal Merger and Acquisition Strategies Mergers and acquisitions are much-used strategic options to strengthen a company’s market position. A merger is the combining of two or more companies into a single corporate entity, with the newly created company often taking on a new name. An acquisition is a combination in which one company, the acquirer, purchases and absorbs the operations of another, the acquired. The difference between a merger and an acquisition relates more to the details of ownership, management control, and financial arrangements than to strategy and competitive advantage. The resources and competitive capabilities of the newly created enterprise end up much the same whether the combination is the result of an acquisition or merger. Horizontal mergers and acquisitions, which involve Combining the operations of two companies, combining the operations of companies within the via merger or acquisition, is an attractive stratesame product or service market, allow companies gic option for achieving operating economies, to rapidly increase scale and horizontal scope. For strengthening the resulting company’s competenexample, the merger of AMR Corporation (parent of cies and competitiveness, and opening avenues American Airlines) with US Airways has increased of new market opportunity. the airlines’ scale of operations and their reach geographically to create the world’s largest airline. Merger and acquisition strategies typically set sights on achieving any of five objectives:12 1. Extending the company’s business into new product categories. Many times a company has gaps in its product line that need to be filled. Acquisition can be a quicker and more potent way to broaden a company’s product line than going 120  Part 1  Section C: Crafting a Strategy through the exercise of introducing a company’s own new product to fill the gap. Coca-Cola has expanded its offerings by acquiring Minute Maid, Glacéau VitaminWater, and Hi-C. 2. Creating a more cost-efficient operation out of the combined companies. When a company acquires another company in the same industry, there’s usually enough overlap in operations that certain inefficient plants can be closed or distribution and sales activities can be partly combined and downsized. The combined companies may also be able to reduce supply chain costs through buying in greater volume from common suppliers. Likewise, it is usually feasible to squeeze out cost savings in administrative activities, again by combining and downsizing such activities as finance and accounting, information technology, human resources, and so on. 3. Expanding a company’s geographic coverage. One of the best and quickest ways to expand a company’s geographic coverage is to acquire rivals with operations in the desired locations. Food products companies such as Nestlé, Kraft, Unilever, and Procter & Gamble have made acquisitions an integral part of their strategies to expand internationally. 4. Gaining quick access to new technologies or complementary resources and capabilities. Making acquisitions to bolster a company’s technological know-how or to expand its skills and capabilities allows a company to bypass a time-consuming and expensive internal effort to build desirable new resources and capabilities. From 2000 through June 2015, Cisco Systems purchased 121 companies to give it more technological reach and product breadth, thereby enhancing its standing as the world’s largest provider of hardware, software, and services for building and operating Internet networks. 5. Leading the convergence of industries whose boundaries are being blurred by changing technologies and new market opportunities. Such acquisitions are the result of a company’s management betting that two or more distinct industries are converging into one and deciding to establish a strong position in the consolidating markets by bringing together the resources and products of several different companies. News Corporation has prepared for the convergence of media services with the purchase of satellite TV companies to complement its media holdings in TV broadcasting (the Fox network and TV stations in various countries), cable TV (Fox News, Fox Sports, and FX), filmed entertainment (Twentieth Century Fox and Fox Studios), newspapers, magazines, and book publishing. Why Mergers and Acquisitions Sometimes Fail to Produce Anticipated Results Despite many successes, mergers and acquisitions do not always produce the hopedfor outcomes.13 Cost savings may prove smaller than expected. Gains in competitive capabilities may take substantially longer to realize or, worse, may never materialize. Efforts to mesh the corporate cultures can stall due to formidable resistance from organization members. Key employees at the acquired company can quickly become disenchanted and leave; the morale of company personnel who remain can drop to disturbingly low levels because they disagree with newly instituted changes. Differences in management styles and operating procedures can prove hard to resolve. In addition, Chapter 6  Strengthening a Company’s Competitive Position   121 & Concepts Connections 6.2 AMAZON.COM’S FIRST-MOVER ADVANTAGE IN ONLINE RETAILING’s path to becoming the world’s largest online retailer began in 1994 when Jeff Bezos, a Manhattan hedge fund analyst at the time, noticed that the number of Internet users was increasing by 2,300 percent annually. Bezos saw the tremendous growth as an opportunity to sell products online that would be demanded by a large number of Internet users and could be easily shipped. Bezos launched the online bookseller in 1995. The startup’s revenues soared to $148 million in 1997, $610 million in 1998, and $1.6 billion in 1999. Bezos’s business plan—hatched while on a cross-country trip with his wife in 1994—made him Time magazine’s Person of the Year in 1999. The volume-based and reputational benefits of’s early entry into online retailing had delivered a first-mover advantage, but between 2000 and 2013, Bezos undertook a series of additional strategic initiatives to solidify the company’s numberone ranking in the industry. Bezos undertook a massive building program in the late-1990s that added five new warehouses and fulfillment centers at a total cost of $300 million. The additional warehouse capacity was added years before it was needed, but Bezos wanted to move preemptively against potential rivals and ensure that, as demand continued to grow, the company could continue to offer its customers the best selection, the lowest prices, and the cheapest and most convenient delivery. The company also expanded its product line to include sporting goods, tools, toys, grocery items, electronics, and digital music downloads, giving it another means of maintaining its experience and scale-based advantages.’s 2013 revenues of $74.5 billion not only made it the world’s leading Internet retailer but made it larger than its 12 biggest competitors combined. As a result, Jeff Bezos’s shares in made him the 12th wealthiest person in the United States, with an estimated net worth of $27.2 billion. Moving down the learning curve in Internet retailing was not an entirely straightforward process for Bezos commented in a Fortune article profiling the company, “We were investors in every bankrupt, 1999-vintage e-commerce startup:,, We invested in a lot of highprofile flameouts.” He went on to specify that although the ventures were a “waste of money,” they “didn’t take us off our own mission.” Bezos also suggested that gaining advantage as a first mover is “taking a million tiny steps—and learning quickly from your missteps.” Sources: Mark Brohan, “The Top 500 Guide,”Internet Retailer, June 2009, (accessed June 17, 2009); Josh Quittner, “How Jeff Bezos Rules the Retail Space,” Fortune, May 5, 2008, pp. 126–134; S. Banjo and P. Ziobro, “After Decades of Toil, Web Sales Remain Small for Many Retailers,” Wall Street Journal Online, August 27, 2013 (accessed March 2014); Company Snapshot, Bloomberg Businessweek Online (accessed March 28, 2014);; and company website. the managers appointed to oversee the integration of a newly acquired company can make mistakes in deciding which activities to leave alone and which activities to meld into their own operations and systems. A number of mergers/acquisitions have been notably unsuccessful. The 2008 merger of Arby’s and Wendy’s is a prime example. After only three years, Wendy’s decided to sell Arby’s due to the roast beef sandwich chain’s continued poor profit performance. The jury is still out as to whether Microsoft’s 2011 acquisition of Skype for $8.5 billion or the $3 billion merger of United Airlines and Continental Airlines in 2010 will prove to be moneymakers or money losers. 122  Part 1  Section C: Crafting a Strategy LO4   Learn the advantages and disadvantages of extending a company’s scope of operations via vertical integration. Vertical Integration Strategies Vertical integration extends a firm’s competitive and operating scope within the same industry. It involves expanding the firm’s range of value chain activities backward into sources of supply and/or forward toward end users. Thus, if a manufacturer invests in facilities to produce certain component parts that it formerly purchased from outside suppliers or if it opens its own chain of retail stores to market its products to consumers, it is engagCORE CONCEPT ing in vertical integration. For example, paint manufacA vertically integrated firm is one that performs turer Sherwin-Williams remains in the paint business value chain activities along more than one stage even though it has integrated forward into retailing by of an industry’s overall value chain operating more than 4,000 retail stores that market its paint products directly to consumers. A firm can pursue vertical integration by starting its own operations in other stages of the vertical activity chain, by acquiring a company already performing the activities it wants to bring in-house, or by means of a strategic alliance or joint venture. Vertical integration strategies can aim at full integration (participating in all stages of the vertical chain) or partial integration (building positions in selected stages of the vertical chain). Companies may choose to pursue tapered integration, a strategy that involves both outsourcing and performing the activity internally. Oil companies’ practice of supplying their refineries with both crude oil produced from their own wells and crude oil supplied CORE CONCEPT by third-party operators and well owners is an example Backward integration involves performing industry value chain activities previously performed of tapered backward integration. Coach, Inc., the maker by suppliers or other enterprises engaged in of Coach handbags and accessories, engages in tapered earlier stages of the industry value chain; forward forward integration since it operates full-price and fac­integration involves performing industry value tory outlet stores but also sells its products through chain activities closer to the end user. third-party department store outlets. The Advantages of a Vertical Integration Strategy The two best reasons for investing company resources in vertical integration are to strengthen the firm’s competitive position and/or to boost its profitability.14 Vertical integration has no real payoff unless it produces sufficient cost savings to justify the extra investment, adds materially to a company’s technological and competitive strengths, and/or helps differentiate the company’s product offering. Integrating Backward to Achieve Greater Competitiveness  It is harder than one might think to generate cost savings or boost profitability by integrating backward into activities such as parts and components manufacture. For backward integration to be a viable and profitable strategy, a company must be able to (1) achieve the same scale economies as outside suppliers and (2) match or beat suppliers’ production efficiency with no decline in quality. Neither outcome is easily achieved. To begin with, a company’s in-house requirements are often too small to reach the optimum size for low-cost operation; for instance, if it takes a minimum production volume of 1 ­million units to achieve scale economies and a company’s in-house requirements are just 250,000 units, then it falls way short of being able to match the costs of outside suppliers (who may readily find buyers for 1 million or more units). Chapter 6  Strengthening a Company’s Competitive Position   123 But that said, there are still occasions when a company can improve its cost position and competitiveness by performing a broader range of value chain activities inhouse rather than having these activities performed by outside suppliers. The best potential for being able to reduce costs via a backward integration strategy exists in situations where suppliers have very large profit margins, where the item being supplied is a major cost component, and where the requisite technological skills are easily mastered or acquired. Backward vertical integration can produce a differentiation-based competitive advantage when performing activities internally contributes to a better-quality product/service offering, improves the caliber of customer service, or in other ways enhances the performance of a final product. Other potential advantages of backward integration include sparing a company the uncertainty of being dependent on suppliers for crucial components or support services and lessening a company’s vulnerability to powerful suppliers inclined to raise prices at every opportunity. Spanish clothing maker Inditex has backward integrated into fabric making, as well as garment design and manufacture, for its successful Zara chain of clothing stores. By tightly controlling the design and production processes, it can quickly respond to changes in fashion trends to keep its stores stocked with the hottest new items and lines. Integrating Forward to Enhance Competitiveness  Vertical integration into for- ward stages of the industry value chain allows manufacturers to gain better access to end users, improve market visibility, and include the end user’s purchasing experience as a differentiating feature. For example, Harley-Davidson’s company-owned retail stores bolster the company’s image and appeal through personalized selling, attractive displays, and riding classes that create new motorcycle riders and build brand loyalty. Insurance companies and brokerages such as Allstate and Edward Jones have the ability to make consumers’ interactions with local agents and office personnel a differentiating feature by focusing on building relationships. Most consumer goods companies have opted to integrate forward into retailing by selling direct to consumers via their websites. Bypassing regular wholesale/retail channels in favor of direct sales and Internet retailing can have appeal if it lowers distribution costs, produces a relative cost advantage over certain rivals, offers higher margins, or results in lower selling prices to end users. In addition, sellers are compelled to include the Internet as a retail channel when a sufficiently large number of buyers in an industry prefer to make purchases online. However, a company that is vigorously pursuing online sales to consumers at the same time that it is also heavily promoting sales to consumers through its network of wholesalers and retailers is competing directly against its distribution allies. Such actions constitute channel conflict and create a tricky route to negotiate. A company that is actively trying to grow online sales to consumers is signaling a weak strategic commitment to its dealers and a willingness to cannibalize dealers’ sales and growth potential. The likely result is angry dealers and loss of dealer goodwill. Quite possibly, a company may stand to lose more sales by offending its dealers than it gains from its own online sales effort. Consequently, in industries where the strong support and goodwill of dealer networks are essential, companies may conclude that it is important to avoid channel conflict and that their website should be designed to partner with dealers rather than compete with them. 124  Part 1  Section C: Crafting a Strategy & Concepts Connections 6.3 KAISER PERMANENTE’S VERTICAL INTEGRATION STRATEGY Kaiser Permanente’s unique business model features a vertical integration strategy that enables it to deliver higher-quality care to patients at a lower cost. Kaiser Permanente is the largest vertically integrated health care delivery system in the United States, with $53.1 billion in revenues and $2.7 billion in net income in 2013. It functions as a health insurance company with over 9 million members and a provider of health care services with 37 hospitals, 618 medical offices, and more than 17,000 physicians. As a result of its vertical integration, Kaiser Permanente is better able to efficiently match demand for services by health plan members to capacity of its delivery infrastructure, including physicians and hospitals. Moreover, its prepaid financial model helps to incentivize the appropriate delivery of health care services. Unlike Kaiser Permanente, the majority of physicians and hospitals in the United States provide care on a fee-for-service revenue model or per-procedure basis. Consequently, most physicians and hospitals earn higher revenues by providing more services, which limits investments in preventive care. In contrast, Kaiser Permanente providers are incentivized to focus on health promotion, disease prevention, and chronic disease management. Kaiser Permanente pays primary care physicians more than local averages to attract top talent, and surgeons are salaried rather than paid by procedure to encourage the optimal level of care. Physicians from multiple specialties work collaboratively to coordinate care and treat the overall health of patients rather than individual health issues. One result of this strategy is enhanced efficiency, enabling Kaiser Permanente to provide health insurance that is, on average, 10 percent cheaper than that of its competitors. Further, the care provided is of higher quality based on national standards of care. For the sixth year in a row, Kaiser Permanente health plans received the highest overall quality-of-care rating of any health plan in California, which accounts for 7 million of its 9 million members. Kaiser Permanente is also consistently praised for member satisfaction. Four of Kaiser’s health plan regions, accounting for 90 percent of its membership, were ranked highest in member satisfaction by J. D. Power and Associates. The success of Kaiser Permanente’s vertical integration strategy is the primary reason why many health care organizations are seeking to replicate its model as they transition from a fee-for-service revenue model to an accountable care model. Note: Developed with Christopher C. Sukenik. Sources: “Kaiser Foundation Hospitals and Health Plan Report Fiscal Year 2013 and Fourth Quarter Financial Results,” PRNewswire, February 14, 2014,; Kaiser Permanente website and 2012 annual report; and J. O’Donnell, “Kaiser Permanente CEO on Saving Lives, Money,”USA Today, October 23, 2012. The Disadvantages of a Vertical Integration Strategy Vertical integration has some substantial drawbacks beyond the potential for channel conflict.15 The most serious drawbacks to vertical integration include: ∙ Vertical integration increases a firm’s capital investment in the industry. Chapter 6  Strengthening a Company’s Competitive Position   125 ∙ Integrating into more industry value chain segments increases business risk if industry growth and profitability sour. ∙ Vertically integrated companies are often slow to embrace technological advances or more-efficient production methods when they are saddled with older technology or facilities. ∙ Integrating backward potentially results in less flexibility in accommodating shifting buyer preferences when a new product design doesn’t include parts and components that the company makes in-house. ∙ Vertical integration poses all kinds of capacity matching problems. In motor vehicle manufacturing, for example, the most efficient scale of operation for making axles is different from the most economic volume for radiators and different yet again for both engines and transmissions. Consequently, integrating across several production stages in ways that achieve the lowest feasible costs can be a monumental challenge. ∙ Integration forward or backward often requires the development of new skills and business capabilities. Parts and components manufacturing, assembly operations, wholesale distribution and retailing, and direct sales via the Internet are different businesses with different key success factors. Kaiser Permanente, the largest managed care organization in the Untied States, has made vertical integration a central part of its strategy, as described in Concepts & Connections 6.3. A vertical integration strategy has appeal only if it significantly strengthens a firm’s competitive ­position and/or boosts its profitability. Outsourcing Strategies: Narrowing the Scope of Operations LO5   Understand the Outsourcing forgoes attempts to perform certain value chain activities internally and instead farms them out to outside specialists and strategic allies. Outsourcing makes strategic sense whenever: ∙ ∙ An activity can be performed better or more cheaply by outside specialists. A company should generally not perform any value chain activity internally that can be performed more efficiently or effectively by outsiders. The chief exception is when a particular activity is strategically crucial and internal control over that activity is deemed essential. conditions that favor farming out certain value chain activities to outside parties. CORE CONCEPT Outsourcing involves contracting out certain value chain activities to outside specialists and strategic allies. The activity is not crucial to the firm’s ability to achieve sustainable competitive advantage and won’t hollow out its capabilities, core competencies, or technical know-how. Outsourcing of support activities such as maintenance services, data processing and data storage, fringe benefit management, and website operations has become common. Colgate-Palmolive, for instance, has been able to reduce its information technology operational costs by more than 10 percent per year through an outsourcing agreement with IBM. 126  Part 1  Section C: Crafting a Strategy ∙ It improves organizational flexibility and speeds time to market. Outsourcing gives a company the flexibility to switch suppliers in the event that its present supplier falls behind competing suppliers. Also, to the extent that its suppliers can speedily get next-generation parts and components into production, a company can get its own next-generation product offerings into the marketplace quicker. ∙ It reduces the company’s risk exposure to changing technology and/or buyer preferences. When a company outsources certain parts, components, and services, its suppliers must bear the burden of incorporating state-of-the-art technologies and/or undertaking redesigns and upgrades to accommodate a company’s plans to introduce next-generation products. ∙ It allows a company to concentrate on its core business, leverage its key resources and core competencies, and do even better what it already does best. A company is better able to build and develop its own competitively valuable competencies and capabilities when it concentrates its full resources and energies on performing those activities. Nike, for example, devotes its energy to designing, marketing, and distributing athletic footwear, sports apparel, and sports equipment, while outsourcing the manufacture of all its products to some 785 contract factories in nearly 50 countries. Apple also outsources production of its iPod, iPhone, and iPad models to Chinese A company should guard against outsourcing contract manufacturer Foxconn. Hewlett-Packard and activities that hollow out the resources and capaothers have sold some of their manufacturing plants to bilities that it needs to be a master of its own outsiders and contracted to repurchase the output from destiny. the new owners. The Big Risk of an Outsourcing Strategy  The biggest danger of outsourcing is that a company will farm out the wrong types of activities and thereby hollow out its own capabilities.16 In such cases, a company loses touch with the very activities and expertise that over the long run determine its success. But most companies are alert to this danger and take actions to protect against being held hostage by outside suppliers. Cisco Systems guards against loss of control and protects its manufacturing expertise by designing the production methods that its contract manufacturers must use. Cisco keeps the source code for its designs proprietary, thereby controlling the initiation of all improvements and safeguarding its innovations from imitation. Further, Cisco uses the Internet to monitor the factory operations of contract manufacturers around the clock and can know immediately when problems arise and decide whether to get involved. LO6   Gain an understanding of how strategic alliances and collaborative partnerships can bolster a company’s collection of resources and capabilities. Strategic Alliances and Partnerships Companies in all types of industries have elected to form strategic alliances and partnerships to complement their accumulation of resources and capabilities and strengthen their competitiveness in domestic and international markets. A strategic alliance is a formal agreement between two or more separate companies in which there is strategically relevant collaboration of some sort, joint contribution of resources, shared risk, shared control, and mutual dependence. Collaborative relationships between partners may entail a contractual agreement, but they commonly stop short of formal ownership ties between the partners (although there are a few strategic alliances where one Chapter 6  Strengthening a Company’s Competitive Position   127 or more allies have minority ownership in certain of CORE CONCEPT the other alliance members). Collaborative arrangeA strategic alliance is a formal agreement ments involving shared ownership are called joint between two or more companies to work coopventures. A joint venture is a partnership involving eratively toward some common objective. the establishment of an independent corporate entity that is jointly owned and controlled by two or more companies. Since joint ventures involve setting up a mutually owned business, they tend to be more durable but also riskier than other arrangements. The most common reasons companies enter into strategic alliances are to expedite the development of promising new technologies or products, to overcome deficits in their own technical and manufacturing expertise, to bring together the personnel and expertise needed to create desirable new skill sets and capabilities, to improve supply chain efficiency, to gain economies of scale in production and/or marketing, and to acquire or improve market access through joint marketing agreements.17 Shell Oil Company and Mexico’s Pemex have found that joint ownership of their Deer Park Refinery in Texas lowers their investment costs and risks in comparison to going it alone. In 2013, Ford Motor Company joined Daimler AG and Renault-Nissan in an effort to develop affordable, mass-market hydrogen fuel cell vehicles by 2017. Because of the varied benefits of strategic alliances, many large corporations have become involved in 30 to 50 alliances, and a number have formed hundreds of alliances. Genentech, a leader in biotechnology and human genetics, has formed R&D alliances with over 30 companies to boost its prospects for developing new cures for various diseases and ailments. Companies that have formed a host of alliances need to manage their alliCORE CONCEPT ances like a portfolio—terminating those that no A joint venture is a type of strategic alliance that longer serve a useful purpose or that have produced involves the establishment of an independent cormeager results, forming promising new alliances, and porate entity that is jointly owned and controlled restructuring existing alliances to correct performance by the two partners. problems and/or redirect the collaborative effort. Failed Strategic Alliances and Cooperative Partnerships Most alliances with an objective of technology sharing or providing market access turn out to be temporary, fulfilling their purpose after a few years because the benefits of mutual learning have occurred. Although long-term alliances sometimes prove mutually beneficial, most partners don’t hesitate to terminate the alliance and go it alone when the payoffs run out. Alliances are more likely to be long lasting when (1) they involve collaboration with partners that do not compete directly, (2) a trusting relationship has been established, and (3) both parties conclude that continued collaboration is in their mutual interest, perhaps because new opportunities for learning are emerging. A surprisingly large number of alliances never live up to expectations, with estimates that as many as 60 to 70 percent of alliances fail each year. The high “divorce rate” among strategic allies has several causes, the most common of which are:18 ∙ Diverging objectives and priorities. ∙ An inability to work well together. ∙ Changing conditions that make the purpose of the alliance obsolete. 128  Part 1  Section C: Crafting a Strategy ∙ The emergence of more attractive technological paths. ∙ Marketplace rivalry between one or more allies. Experience indicates that alliances stand a reasonable chance of helping a company reduce competitive disadvantage, but very rarely have they proved a strategic option for gaining a durable competitive edge over rivals. The Strategic Dangers of Relying on Alliances for Essential Resources and Capabilities The Achilles’ heel of alliances and cooperative strategies is becoming dependent on other companies for essential expertise and capabilities. To be a market leader (and perhaps even a serious market contender), a company must ultimately develop its own resources and capabilities in areas where internal strategic control is pivotal to protecting its competitiveness and building competitive advantage. Moreover, some alliances hold only limited potential because the partner guards its most valuable skills and expertise; in such instances, acquiring or merging with a company possessing the desired know-how and resources is a better solution. KEY POINTS Once a company has selected which of the five basic competitive strategies to employ in its quest for competitive advantage, then it must decide whether and how to supplement its choice of a basic competitive strategy approach. 1. Companies have a number of offensive strategy options for improving their market positions and trying to secure a competitive advantage: (1) attacking competitors’ weaknesses, (2) offering an equal or better product at a lower price, (3) pursuing sustained product innovation, (4) leapfrogging competitors by being first to adopt next-generation technologies or the first to introduce next-generation products, (5) adopting and improving on the good ideas of other companies, (6) deliberately attacking those market segments where key rivals make big profits, (7) going after less contested or unoccupied market territory, (8) using hit-and-run tactics to steal sales away from unsuspecting rivals, and (9) launching preemptive strikes. A blue ocean offensive strategy seeks to gain a dramatic and durable competitive advantage by abandoning efforts to beat out competitors in existing markets and, instead, inventing a new industry or distinctive market segment that renders existing competitors largely irrelevant and allows a company to create and capture altogether new demand. 2. Defensive strategies to protect a company’s position usually take the form of making moves that put obstacles in the path of would-be challengers and fortify the company’s present position while undertaking actions to dissuade rivals from even trying to attack (by signaling that the resulting battle will be more costly to the challenger than it is worth). 3. The timing of strategic moves also has relevance in the quest for competitive advantage. Company managers are obligated to carefully consider the advantages or disadvantages that attach to being a first mover versus a fast follower versus a wait-and-see late mover. 4. Decisions concerning the scope of a company’s operations can also affect the strength of a company’s market position. The scope of the firm refers to the range of its activities, the breadth of its product and service offerings, the extent of its geographic market presence, and its mix of businesses. Companies can expand their scope horizontally (more broadly within their focal market) or vertically (up or down the industry value chain system that starts with raw-materials production and ends with sales and service to the end consumer). Horizontal mergers and acquisitions (combinations of market rivals) provide a means for a company to expand its horizontal scope. Vertical integration expands a firm’s vertical scope. 5. Horizontal mergers and acquisitions can be an attractive strategic option for strengthening a firm’s competitiveness. When the operations of two companies are combined via merger or acquisition, the new company’s competitiveness can be enhanced in any of several ways—lower costs; stronger technological skills; more or better competitive capabilities; a more attractive lineup of products and services; wider geographic coverage; and/or greater financial resources with which to invest in R&D, add capacity, or expand into new areas. 6. Vertically integrating forward or backward makes strategic sense only if it strengthens a company’s position via either cost reduction or creation of a differentiation-based advantage. Otherwise, the drawbacks of vertical integration (increased investment, greater business risk, increased vulnerability to technological changes, and less flexibility in making product changes) are likely to outweigh any advantages. 7. Outsourcing pieces of the value chain formerly performed in-house can enhance a company’s competitiveness whenever (1) an activity can be performed better or more cheaply by outside specialists; (2) the activity is not crucial to the firm’s ability to achieve sustainable competitive advantage and won’t hollow out its core competencies, capabilities, or technical know-how; (3) it improves a company’s ability to innovate; and/or (4) it allows a company to concentrate on its core business and do what it does best. 8. Many companies are using strategic alliances and collaborative partnerships to help them in the race to build a global market presence or be a leader in the industries of the future. Strategic alliances are an attractive, flexible, and often cost-effective means by which companies can gain access to missing technology, expertise, and business capabilities. ASSURANCE OF LEARNING EXERCISES 1. Live Nation operates music venues, provides management services to music artists, and promotes more than 22,000 live music events annually. The company merged with Ticketmaster and acquired concert and festival promoters in the United States, Australia, and Great Britain. How has the company used horizontal mergers and acquisitions to strengthen its competitive position? Are these moves primarily offensive or defensive? Has either Live Nation or Ticketmaster achieved any type of advantage based on the timing of its strategic moves? 2. Kaiser Permanente, a standout among managed health care systems, has become a model for how to deliver good health care cost-effectively. Concepts & Connections 6.3 describes how Kaiser Permanente has made vertical integration a central part of its strategy. What value chain segments has Kaiser Permanente chosen to enter and perform internally? How has vertical integration aided the company in building competitive advantage? Has vertical integration strengthened its market position? Explain why or why not. LO1, LO2, LO3 LO4 129 LO5 3. LO6 4. Perform an Internet search to identify at least two companies in different industries that have entered into outsourcing agreements with firms with specialized services. In addition, describe what value chain activities the companies have chosen to outsource. Do any of these outsourcing agreements seem likely to threaten any of the companies’ competitive capabilities? Using your university library’s subscription to Lexis-Nexis, EBSCO, or a similar database, find two examples of how companies have relied on strategic alliances or joint ventures to substitute for horizontal or vertical integration. EXERCISES FOR SIMULATION PARTICIPANTS LO1, LO2 1. Has your company relied more on offensive or defensive strategies to achieve your rank in the industry? What options for being a first mover does your company have? Do any of these first-mover options hold competitive advantage potential? LO3 2. Does your company have the option to merge with or acquire other companies? If so, which rival companies would you like to acquire or merge with? LO4 LO5 3. Is your company vertically integrated? Explain. 4. Is your company able to engage in outsourcing? If so, what do you see as the pros and cons of outsourcing? ENDNOTES 1. GeorgeStalk, Jr., and Rob Lachenauer, “Hardball: Five Killer Strategies for Trouncing the Competition,” Harvard Business Review 82, no. 4 (April 2004); Richard D’Aveni, “The Empire Strikes Back: Counterrevolutionary Strategies for Industry Leaders,” Harvard Business Review 80, no. 11 (November 2002); David J. Bryce and Jeffrey H. Dyer, “Strategies to Crack WellGuarded Markets,” Harvard Business Review 85, no. 5 (May 2007). 2. David B. Yoffie and Mary Kwak, “Mastering Balance: How to Meet and Beat a Stronger Opponent,” California Management Review 44, no. 2 (Winter 2002). 3. Ian C. MacMillan, Alexander B. van Putten, and Rita Gunther McGrath, “Global Gamesmanship,” Harvard Business Review 81, no. 5 (May 2003); Askay R. Rao, Mark E. Bergen, and Scott Davis, “How to Fight a Price War,” Harvard Business Review 78, no. 2 (March–April 2000). 4. Ming-Jer Chen and Donald C. ­Hambrick, “Speed, Stealth, and Selective Attack: How Small Firms Differ 130 from Large Firms in Competitive Behavior,” Academy of Management Journal 38, no. 2 (April 1995); Ian MacMillan, “How Business Strategists Can Use Guerrilla Warfare Tactics,” Journal of Business Strategy 1, no. 2 (Fall 1980); William E. Rothschild, “Surprise and the Competitive Advantage,” Journal of Business Strategy 4, no. 3 (Winter 1984); Kathryn R. Harrigan, Strategic Flexibility (Lexington, MA: Lexington Books, 1985); Liam Fahey, “Guerrilla Strategy: The Hit-and-Run Attack,” in The Strategic Management Planning Reader, ed. Liam Fahey (Englewood Cliffs, NJ: Prentice Hall, 1989). 5. Ian MacMillan, “Preemptive Strategies,” Journal of Business Strategy 14, no. 2 (Fall 1983). 6. W. Chan Kim and Renée Mauborgne, “Blue Ocean Strategy,” Harvard Business Review 82, no. 10 (October 2004). 7. Michael E. Porter, Competitive Advantage (New York: Free Press, 1985). 8. Jeffrey G. Covin, Dennis P. Slevin, and Michael B. Heeley, “Pioneers and Followers: Competitive Tactics, Environment, and Growth,” Journal of Business Venturing 15, no. 2 (March 1999); Christopher A. Bartlett and Sumantra Ghoshal, “Going Global: Lessons from Late-Movers,” Harvard Business Review 78, no. 2 (March–April 2000). 9. Fernando Suarez and Gianvito ­Lanzolla, “The Half-Truth of FirstMover Advantage,” Harvard Business Review 83 no. 4 (April 2005). 10. Gary Hamel, “Smart Mover, Dumb Mover,” Fortune, September 3, 2001. 11. Costas Markides and Paul A. Geroski, “Racing to Be 2nd: Conquering the Industries of the Future,” Business Strategy Review 15, no. 4 (Winter 2004). 12. Joseph L. Bower, “Not All M&As Are Alike—and That Matters,” Harvard Business Review 79, no. 3 (March 2001); O. Chatain and P. Zemsky, “The Horizontal Scope of the Firm: Organizational Tradeoffs vs. Buyer–Supplier Relationships,” Management Science 53, no. 4 (April 2007), pp. 550–65. 13. Jeffrey H. Dyer, Prashant Kale, and Harbir Singh, “When to Ally and When to Acquire,” Harvard Business Review 82, no. 4 (July–August 2004), pp. 109–10. 14. Kathryn R. Harrigan, “Matching Vertical Integration Strategies to Competitive Conditions,” Strategic Management Journal 7, no. 6 (November–December 1986); John Stuckey and David White, “When and When Not to Vertically Integrate,” Sloan Management Review, Spring 1993. 15. Thomas Osegowitsch and Anoop Madhok, “Vertical Integration Is Dead, or Is It?” Business Horizons 46, no. 2 (March–April 2003). 16. Jérôme Barthélemy, “The Seven Deadly Sins of Outsourcing,” Academy of Management Executive 17, no. 2 (May 2003); Gary P. Pisano and Willy C. Shih, “Restoring American Competitiveness,” Harvard Business Review 87, no. 7/8 (July–August 2009); Ronan McIvor, “What Is the Right Outsourcing Strategy for Your Process?” European Management Journal 26, no. 1 (February 2008). 17. Michael E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990); K. M. Eisenhardt and C. B. Schoonhoven, “Resource-Based View of Strategic Alliance Formation: Strategic and Social Effects in Entrepreneurial Firms,” Organization Science 7, no. 2 (March–April 1996); Nancy J. Kaplan and Jonathan Hurd, “Realizing the Promise of Partnerships,” Journal of Business Strategy 23, no. 3 (May–June 2002); Salvatore Parise and Lisa Sasson, “Leveraging Knowledge Management across Strategic Alliances,” Ivey Business Journal 66, no. 4 (March–April 2002); David Ernst and James Bamford, “Your Alliances Are Too Stable,” Harvard Business Review 83, no. 6 (June 2005). 18. Yves L. Doz and Gary Hamel, Alliance Advantage; The Art of Creating Value Through Partnering (Boston: Harvard Business School Press, 1998). 131
APPENDIX Key Financial Ratios: How to Calculate Them and What They Mean Ratio How Calculated What It Shows Sales revenues – Cost of goods sold __________________ ​         ​ Sales revenues Shows the percentage of revenues available to cover operating expenses and yield a profit. Higher is better, and the trend should be upward. Profitability Ratios 1. Gross profit margin 2. Operating profit margin (or return on sales) Sales revenues – Operating expenses ___________________ ​        ​ Sales revenues  or Operating income _________ ​    Sales revenues  ​  3. Net profit margin (or net return on sales) 4. Total return on assets 5. Net return on total assets (ROA) 6. Return on stockholder’s equity 7. Return on invested capital (ROIC) – sometimes referred to as return on capital (ROCE) 8. Earnings per share (EPS) after taxes _________    ​  Profits Sales revenues  ​  ______________    ​  Profits after taxes + Interest   ​   Total assets _________    ​  Profits after taxes   ​  Total assets Profits after taxes _____________    ​    Total stockholders’ equity ​ Shows the profitability of current operations without regard to interest charges and income taxes. Higher is better, and the trend should be upward. Shows after-tax profits per dollar of sales. Higher is better, and the trend should be upward. A measure of the return on total monetary investment in the enterprise. Interest is added to after-tax profits to form the numerator since total assets are financed by creditors as well as by stockholders. Higher is ­better, and the trend should be upward. A measure of the return earned by stockholders on the firm’s total assets. Higher is better, and the trend should be upward. Shows the return stockholders are earning on their capital investment in the enterprise. A return in the 12–15% range is “average,” and the trend should be upward. Profits after taxes _____________________ A measure of the return shareholders are earning on the long-term    ​    Long term debt + Total stockholders’ equity ​ monetary capital invested in the enterprise. Higher is better, and the trend should be upward. Profits after taxes _______________    ​ Number    of shares of common ​ stock outstanding Shows the earnings for each share of common stock outstanding. The trend should be upward, and the bigger the annual percentage gains, the better. Liquidity Ratios 1. Current ratio 2. Working capital Current assets _________ ​  Current  ​  liabilities  Current assets – Current liabilities Shows a firm’s ability to pay current liabilities using assets that can be converted to cash in the near term. Ratio should definitely be higher than 1.0; ratios of 2 or higher are better still. Bigger amounts are better because the company has more internal funds available to (1) pay its current liabilities on a timely basis and (2) finance inventory expansion, additional accounts receivable, and a larger base of operations without resorting to borrowing or raising more equity capital. Leverage Ratios 1. Total debtto-assets ratio 228 ______ ​  Total debt   ​  Total assets Measures the extent to which borrowed funds (both short-term loans and long-term debt) have been used to finance the firm’s operations. A low fraction or ratio is better—a high fraction indicates overuse of debt and greater risk of bankruptcy. Appendix  229 Ratio 2. Long-term debt-to-capital ratio How Calculated Long-term debt ______________________    ​ Long-term    debt + Total stockholders’ equity ​ 3. Debt-to-equity ratio Total debt _____________       ​  stockholders’ Total equity ​ 4. Long-term debtto-equity ratio Long-term debt _____________    ​ Total    stockholders’ equity ​ 5. Times-interest-earned (or coverage) ratio Operating income _________ ​    Interest expenses ​  What It Shows An important measure of creditworthiness and balance sheet strength. It indicates the percentage of capital investment in the enterprise that has been financed by both long-term lenders and stockholders. A ratio below 0.25 is usually preferable since monies invested by stockholders account for 75% or more of the company’s total capital. The lower the ratio, the greater the capacity to borrow additional funds. Debt-to-capital ratios above 0.50 and certainly above 0.75 indicate a heavy and perhaps excessive reliance on long-term borrowing, lower creditworthiness, and weak balance sheet strength. Shows the balance between debt (funds borrowed both short-term and long-term) and the amount that stockholders have invested in the enterprise. The farther the ratio is below 1.0, the greater the firm’s ability to borrow additional funds. Ratios above 1.0 and definitely above 2.0 put creditors at greater risk, signal weaker balance sheet strength, and often result in lower credit ratings. Shows the balance between long-term debt and stockholders’ equity in the firm’s long-term capital structure. Low ratios indicate greater capacity to borrow additional funds if needed. Measures the ability to pay annual interest charges. Lenders usually insist on a minimum ratio of 2.0, but ratios progressively above 3.0 signal progressively better creditworthiness. Activity Ratios 1. Days of inventory 2. Inventory turnover 3. Average collection period Inventory _____________ ​        ​ Cost of goods sold ÷ 365 Cost of goods sold __________ ​    Inventory  ​   receivable __________    ​  Accounts ​ Total sales ÷ 365    or Measures inventory management efficiency. Fewer days of inventory are usually better. Measures the number of inventory turns per year. Higher is better. Indicates the average length of time the firm must wait after making a sale to receive cash payment. A shorter collection time is better. receivable __________    ​  Accounts Average daily sales ​  Other Important Measures of Financial Performance 1. Dividend yield on common stock 2. Price-earnings ratio 3. Dividend payout ratio 4. Internal cash flow 5. Free cash flow Annual dividends per share _______________ ​       Current market price per share ​ Current market price per share _______________    ​  Earnings    ​ per share  Annual dividends per share ______________ ​       Earnings per share  ​ After tax profits + Depreciation After tax profits + Depreciation – Capital expenditures – Dividends A measure of the return that shareholders receive in the form of dividends. A “typical” dividend yield is 2–3%. The dividend yield for fast-growth companies is often below 1% (maybe even 0); the dividend yield for slow-growth companies can run 4–5%. P-E ratios above 20 indicate strong investor confidence in a firm’s outlook and earnings growth; firms whose future earnings are at risk or likely to grow slowly typically have ratios below 12. Indicates the percentage of after-tax profits paid out as dividends. A quick and rough estimate of the cash a company’s business is generating after payment of operating expenses, interest, and taxes. Such amounts can be used for dividend payments or funding capital expenditures. A quick and rough estimate of the cash a company’s business is generating after payment of operating expenses, interest, taxes, dividends, and desirable reinvestments in the business. The larger a company’s free cash flow, the greater is its ability to internally fund new strategic initiatives, repay debt, make new acquisitions, repurchase shares of stock, or increase dividend payments.

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