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Beating low-cost rivals

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Image: Christian HagenWhat makes low-cost competitors so dangerous is their ability to reshape the entire competitive landscape.

Christian Hagen is a principal with A.T. Kearney's IT Strategy Group and is based in Chicago. Advising clients in the financial services, high-tech, energy, and automotive industries, he specializes in helping companies leverage information technology to increase efficiencies, improve customer relationships and gain competitive advantage.

He writes here about strategic responses to low-cost rivals.

By the late 1990s, global network manufacturer Cisco Systems was sitting pretty in China. Offering hardware, software and services for internet solutions, the firm had a 60 percent market share for high-end equipment there. But as Cisco was enjoying cover stories in the world’s leading business publications, Huawei Technologies, a little-known Chinese start-up, quietly entered the networking industry. Beginning in 1998 by importing and developing PBX telephone products, Huawei was unencumbered by inherited costs, able to hire newly minted Chinese engineers at starting salaries of $8,500 a year, and enjoyed a multi-billion dollar credit line from the Chinese government.

Huawei took full advantage of its competitive strengths, reducing networking equipment costs 70 percent compared with Cisco, its much larger rival,. Through partnerships with 3Com and Siemens, Huawei entered new markets, and in the United Kingdom, it won British Telecom’s business, ultimately forcing the domestic incumbent Marconi Corporation onto the selling block. From 2001 to 2005, Huawei’s revenue rose from $2.3 billion to nearly $6 billion, and it cut Cisco’s market share in China to less than 40 percent.

Huawei’s brashly competitive move was built around low costs. But successful low-cost competitors don’t just sap margins incrementally. What makes them so dangerous is their ability to redefine the entire competitive landscape. The low-cost competitor transforms its value chain to reduce prices drastically. With low costs as a pivot, it shifts the ground beneath larger, less flexible opponents and turns their mass and momentum against them. Responses often come too late to be effective, and are hampered by strategic assumptions that no longer apply. Larger rivals soon find they are fighting a war on the new competitor’s terms. Wanting to move quickly, they often cut back on prices to retain customers. If they do so before performing a thoughtful analysis, this action may punish them further. Meanwhile, the Huaweis of the world thrive and continue to gain market share.

The way to beat low-cost competitors that have the potential to become serious competitors is to identify and deal with them early, before they get a foothold in a market.

Sting like a bee

As Cisco learned, even high-tech firms with strong brand identities are not safe from low-cost rivals. Nimble competitors exploit their offshore advantage, partnerships, and inexpensive technologies to break down barriers and rewrite the rules of competition, almost overnight. Following widely different strategies, these firms succeed for one reason: They redesign their value chain to cut costs substantially in an established market.

Consider Nike’s face-off with Steve & Barry’s, a discount clothing chain that captured a niche market in athletic shoes. At under $15 a pair, its Starbury One basketball shoe led a full-court press on the youth market for budget-priced athletic shoes. Instead of relying on superstar endorsements to drive-up the price tag, Steve & Barry’s used their spokesman purely to foster demand. Three million pairs of Starbury sneakers have sold since their August 2006 debut.

Then there is Southwest Airlines. Although known for its no-frills service, the most overlooked aspect of Southwest’s profit-winning strategy is its superior asset utilization. By structuring flight schedules to return planes from the gate to the air in as little as 20 minutes, Southwest flies its planes 20 to 30 percent more hours than the other major airlines. By deploying a point-to-point route network, instead of the hub-and-spoke approach used by most major carriers, Southwest minimizes the domino effect of flight delays and gains maximum use of its assets.

Even Wal-Mart and IKEA, low-cost competitors in their own right, must constantly be on alert for their next threat. While these firms compete on price rather than product differentiation, their retail model is now being challenged by Japanese retailer, Muji. Its stores combine low prices with a high-concept minimalism so that customers don’t have to sacrifice status for cost. The retailer, well established in Europe and Asia, is now moving into the US market.

Low–cost competitors can be right under your nose. A current partner, a supplier or even a contract manufacturer can walk away with key elements of your value chain, establishing its own operations on a modest scale and positioning itself to take more value later by moving upstream or increasing its leverage. That same contract manufacturer may cross boundaries to apply what it learned in one industry to break into another. Case in point is Huawei’s challenge to Cisco.

A low-cost competitor can pursue several strategies along various points of the value chain, and rarely focuses on just one area. These competitors minimize complex and expensive activities such as R&D, product design and marketing, and focus instead on ruthless efficiency. At each step, the new rival chooses the strategies that best deliver lower costs. It keeps the number of SKUs low, standardizes its design and products, outsources assembly to low-cost countries and forms partnerships for activities too costly to build in-house. Cutting costs across the value chain not only enhances its ability but makes it all the more difficult for larger, less flexible companies to respond.

Your hands can’t hit what your eyes can’t see

Many companies fail to recognize the significance of a low-cost competitor until it’s too late. One reason is they are too wedded to the status quo: They develop their strategies in functional silos and according to internal objectives, without considering the entire spectrum of competitor strategies or changes to the external environment. In other words, you are making a serious mistake if your competitive analysis benchmarks your position against the preexisting value chain. In a world of the extended enterprise, analysing competitors is like trying to hit a target capable of rapid transformation. With more diffuse industry barriers, low-cost rivals are outsourcing some parts of their value chain and building partnerships in others. This obscures the true competitive picture and multiplies the number of benchmarking variables.

The best way to identify and thwart a low-cost rival is to adopt its mindset, anticipate its next competitive move and measure your costs against its costs. This requires digging deeper than the qualitative, theoretical approach of war-gaming or the internally focused tools of business-process redesign and lean manufacturing. The goal is to defeat the low-cost rival by compelling actions that allow you to become more competitive and grow or maintain a profitable position in your market segment.

" Even Wal-Mart and IKEA, low-cost competitors in their own right, must constantly be on alert for their next threat. "

This best practice analysis requires four steps:

1. Identify likely low-cost rivals

Identifying low-cost competitors early in the game is crucial. The sooner they can be detected, the less likely it is you’ll be competing on their terms, and the more time you’ll have to plan a response. What to look for? Focus on strategies that offer a cost advantage against your own, for each area of the value chain. Emerging rivals are firms that:

  • Concentrate on a cost-effective design process rather than a unique product design. Reducing complexity in design has a ripple effect on other areas of the value chain, from cost management to procurement and quality. In the 1980s, while U.S. automakers were rolling out large, customized vehicles, Japanese competitors focused on streamlining their processes to cut down on costs and offer affordable models.
  • Involve suppliers early in the process, during initial product design and development.
  • Assemble products in low-cost countries. Companies that develop this mindset and capability give themselves a significant head start and source of advantage.
  • Standardize products to reduce testing. Effective firms also engage their suppliers in the quality process.
  • Engage consumer-to-consumer online communities (eBay and grassfire.com are good examples) and develop low-cost shipping and distribution models via third-party logistics providers.
  • Sell in large volume to developing economies. Low-cost rivals often cover their fixed costs and build up their brands and capabilities by serving emerging markets before moving into established ones. If incumbents are not scanning competitors outside their national markets, they might not spot the new rivals until late in the game.
  • Offer unique online and self-service customer support systems—or find creative solutions in call-centre strategies. For example, JetBlue Airways routes customer service calls to call-centre representatives who work from home, thus saving millions of dollars in real estate overhead.

Internally, consider whether your company is still as profitable as it was six months or a year ago. Because shrinking margins often indicates that a new competitor is undercutting you on price, have a process in place for an ongoing analysis. " Many companies fail to recognize the significance of a low-cost competitor until it’s too late. "

2. Perform a total-cost analysis

A total-cost analysis is used to translate a likely competitor’s advantages into a hypothetical total product or service-cost analysis. This compares your opponent’s "should cost" to actual costs. Questions that should guide the analysis at this point include: How significant is the advantage? How does the cost advantage translate into pricing options? Is it sustainable over time? Most importantly, can we replicate it, and if so, how? Figure 3 shows what happened when a global electronics component supplier used a total-cost analysis to identify potential threats from companies with more efficient supply chains. The analysis was based on detailed plant-by-plant assumptions, which were validated against known cost structures both inside and outside the company. By employing operational best practices, regardless of location, this company could cut costs by 20 percent or more.

3. Develop all potential scenarios

Developing "what-if" scenarios allows you to ascertain likely next steps. Will the low-cost rival reposition itself? Enter new markets? Launch new products? Move into new services? Of course, effective forecasting depends on understanding where the market is going and which low-cost companies have sustainable capabilities. For example, a supplier that is not a low-cost rival today, could become one tomorrow if it develops the right capabilities or if a number of suppliers consolidate. A private-equity firm could even step in and provide funding to enable such a transformation.
These scenarios will probably cause some internal angst as the company weighs whether or not it can make the necessary changes, and if it is likely to lose its most valuable customers as a result. This leads to a crucial fourth step in our analysis.

4. Determine your best strategic moves

At this point you want to make sure the goal is to compete against a low-cost rival by using the information from the what-if scenarios to improve operations and become more competitive overall. The analysis should prompt new questions:

  • Are we focusing on the right things to remain competitive?
  • What can we do immediately to protect our position?
  • What should we do to compete over the medium to long-term given our current strategy?
  • What should we concentrate on first to remain competitive and create value?

Defeating low-cost competitors involves two separate but related tasks. First, stop the bleeding, and second reposition the company for success in the new market. Leaders should break down potential moves into short-term tactics and long-term strategies.

Short-term tactics

Short-term tactics should reinforce a firm’s existing strengths and gain time for the internal and external analysis needed to develop the long-term strategy. These tactics keep low-cost rivals at bay while the company repositions its business. For example, when first confronted by a low-cost rival, companies often respond by lowering prices or providing sales incentives to maintain their market share. Although there are obvious disadvantages and risks to this tactic, it sometimes works; especially if the competitor is relatively weak and doesn’t have the product mix or capabilities to sustain its cash flow. Before attempting this, an incumbent needs to assess the true likelihood that it will outlast its competition and go on to reclaim lost market share. Sometimes another way to protect market share in the short-term is through legal action. As a case in point, Cisco hit Huawei with a patent infringement lawsuit to slow its entry into American and European markets, but eventually dropped its suit when Huawei agreed to modify its products.

Often the better tactic is to shift the competition away from price alone. The newer rival may be less competitive in other areas. Use product differentiation to appeal to customers’ needs for features or benefits they can’t get from the low-cost competitor. In the short-term, differentiation may be enhanced by marketing. Shell Oil did this back in the 1950s when oil companies were all essentially on par. Shell began advertising "platformate," a mileage-boosting additive that some say was common to all gasoline at the time. The sales effort began with a television ad campaign where a car fuelled by Shell without platformate raced against one with the additive. The non-platformate car ran out of gas and stopped while the platformate car was shown passing the stopped car and bursting through a huge paper banner with a Shell logo on it. The ad was a visible illustration of product differentiation and, some say, launched Shell as a major player in the industry.

Finally, focus on your more attractive customers and leave the less profitable ones to your new rivals. Not all customers are equally valuable. Some are prohibitively expensive to serve and draw resources that could be directed elsewhere for bigger gains. Let new rivals take these customers off your hands, so you can concentrate on the more profitable ones. Just don’t make a public announcement of this tactic with a letter, as Sprint did.

What not to do when battling low-cost competition

A key part of your battle plan is establishing what not to do when fighting low-cost competition:

  • Don’t wait for the new rivals to hit you. For example, Sears, K-Mart, and other department stores were slow to respond to Wal-Mart.
  • Don’t respond without first developing a plan. Otherwise, you waste resources on all potential rivals rather than focusing on those that pose an actual threat.
  • Don’t focus solely on current competitors and current products. Companies that may not be direct competitors today could move in with similar products or services tomorrow.
  • Don’t drop your guard against traditional competitors. Old fights don’t end when new ones begin.
  • Don’t try to defeat low-cost rivals by cutting prices alone. Given your competitors’ margins, a price war will almost never work in your favour, unless the competitor can’t sustain its advantage over time.
  • Don’t underestimate the extent of the change management involved. Competing against low-cost rivals is a company-wide effort. Engineering, distribution and marketing, for example, must be realigned to a new strategy, which requires managing change across all aspects of the organization.

Long-term strategies

While long-term strategies involve more risk, the rewards are often worth it. Firms build these strategies to adapt to changed conditions and seize new opportunities – which can sometimes result in a very different company. IBM was the premier manufacturer of personal computers until the 1990s, when Dell and Gateway began selling lower-priced models directly to customers. In the early 1990s it posted a nearly $5 billion loss, the largest of its kind for any American company in a single year. Undaunted, the company set about reinventing its business. By 1995, with the acquisition of Lotus, IBM had a new strategy. Instead of selling components and hardware, it began selling software and service "solutions," bundling products together for a higher-value offer.

Another example comes from the retail propane gas industry where the focus is traditionally on price. One company beat its rivals by ramping up customer service and expanding its delivery options. The gas company decided to invest in technology (global positioning systems, scheduling software, etc.) to transform its field-service operations. These efforts improved deliveries, reduced fixed costs, enhanced asset allocation, increased its ability to match supply with demand, and strengthened customer service – leading to nearly 300 new customers within nine months. The company’s investment had a short payback period and, perhaps more important, the move fundamentally altered the industry’s landscape and performance expectations by creating significant barriers to entry.

Lastly, if you can’t beat your low-cost rivals, steal a page from their playbook and form a low-cost offshoot. United Airlines, tired of competing with the likes of Southwest and other low-cost flyers, came up with its own low-cost rival, Ted.

October 2010.