What Is Strategy?

Learning Objective 1 Recognize which of two generic strategies a company is using

• product differentiation or cost leadership

Strategy specifies how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its objectives. In other words, strategy describes how an organization can create value for its customers while differentiating itself from its competitors. For example, Walmart, the retail giant, creates value for its customers by locating stores in suburban and rural areas and by offering low prices, a wide range of product categories, and few choices within each product category. Consistent with this strategy, Walmart has developed the capability to keep costs down by aggressively negotiating low prices with its suppliers in exchange for high volumes and by maintaining a no-frills, cost-conscious environment with minimal sales staff.

In formulating its strategy, an organization must first thoroughly understand its industry. Industry analysis focuses on five forces: (1) competitors, (2) potential entrants into the market, (3) equivalent products, (4) bargaining power of customers, and (5) bargaining power of input suppliers.^* The collective effect of these forces shapes an organization’s profit potential. In general, profit potential decreases with greater competition, stronger potential entrants, products that are similar, and more demanding customers and suppliers. Below we illustrate these five forces for Chipset, Inc., a maker of linear integrated circuit devices (LICDs) used in amplifiers, modems, and communication networks. Chipset produces a single specialized product, CX1, a standard, high-performance microchip that can be used in multiple applications. Chipset designed CX1 after extensive market research and input from its customer base.

1. COMPETITORS. The CX1 model faces severe competition based on price, timely delivery, and quality. Companies in the industry have high fixed costs and persistent pressures to reduce selling prices and utilize capacity fully. Price reductions spur growth because it makes LICDs a cost-effective option in applications such as digital subscriber lines (DSLs).
2. POTENTIAL ENTRANTS INTO THE MARKET. The small profit margins and high capital costs discourage new entrants. Moreover, incumbent companies such as Chipset have experience lowering costs and building close relationships with customers and suppliers.
3. EQUIVALENT PRODUCTS. Chipset tailors CX1 to customer needs and lowers prices by continuously improving CX1’s design and processes to reduce production costs. This reduces the risk of equivalent products or new technologies replacing CX1.
4. BARGAINING POWER OF CUSTOMERS. Customers, such as EarthLink and Verizon, negotiate aggressively with Chipset and its competitors to keep prices down because they buy large quantities of product.
5. BARGAINING POWER OF INPUT SUPPLIERS. To produce CX1, Chipset requires high-quality materials (such as silicon wafers, pins for connectivity, and plastic or ceramic packaging) and skilled engineers, technicians, and manufacturing labor. The high level of skills required of suppliers and employees gives them bargaining power to demand higher prices and wages.

In summary, strong competition and the bargaining powers of customers and suppliers put significant pressure on Chipset’s selling prices. To respond to these challenges, Chipset must choose between two basic strategies: differentiating its product or achieving cost leadership.

Product differentiation is an organization’s ability to offer products or services its customers perceive to be superior and unique relative to the products or services of its competitors. Apple Inc. has successfully differentiated its products in the consumer electronics industry, as have Johnson & Johnson in the pharmaceutical industry and Coca-Cola in the soft drink industry. These companies have achieved differentiation through innovative product research and development (R&D), careful development and promotion of their brands, and the rapid push of products to market. Managers use differentiation to increase brand loyalty and charge higher prices.

Cost leadership is an organization’s ability to achieve lower costs relative to competitors through productivity and efficiency improvements, elimination of waste, and tight cost control. Cost leaders in their respective industries include McDonald’s and Walmart (consumer products), Home Depot and Lowe’s (home improvement products), Best Buy (consumer electronics), and Emerson Electric (electric motors). These companies provide products and services that are similar to—not differentiated from—their competitors, but at a lower cost to the customer. Lower selling prices, rather than unique products or services, provide a competitive advantage for these cost leaders.

To evaluate the success of its strategy, a company must be able to trace the sources of its profitability to its strategy of product differentiation or cost leadership. For example, Porsche’s source of profitability is closely tied to successfully differentiating its cars from those of its competitors. Product differentiation enables Porsche to increase its profit margins and grow sales. Changes in Home Depot’s profitability are due to successful implementation of its cost-leadership strategy through productivity and quality improvements.

What strategy should Chipset follow? In order to make this decision, Chipset managers develop the customer preference map shown in Exhibit 13-1. The y-axis describes various attributes of the product desired by customers. The x-axis describes how well Chipset and its competitor, Visilog, which follows a product-differentiation strategy, score along various attributes desired by customers from 1 (poor) to 5 (very good). The map highlights the tradeoffs in any strategy. It shows that CX1 enjoys advantages in terms of price, scalability,^* and customer service while Visilog’s chips are faster and more powerful and customized to different types of modems and communication networks.

CX1 is already somewhat differentiated from competing products. Differentiating CX1 further would be costly, but Chipset may be able to charge a higher price. Conversely, reducing the cost of manufacturing CX1 would allow Chipset to lower prices, spur growth, and increase market share. The scalability of CX1 makes it an effective solution for meeting varying customer needs. Chipset has, over the years, recruited an engineering staff that is more skilled at making product and process improvements than at creatively designing new products and technologies. The market benefit from lowering prices by improving manufacturing efficiency through process improvements coupled with its own internal capabilities leads Chipset to choose a cost-leadership strategy.

To achieve its cost-leadership strategy, Chipset has deemed it critical to improve its manufacturing quality and efficiency. This can be achieved by actions such as eliminating excess capacity, reducing defect rates, and training workers in quality-management techniques to identify the root causes of defects and take actions to improve manufacturing quality. At the same time, Chipset’s management team does not want to make cuts in personnel that would hurt company morale and hinder future growth. In addition to improving manufacturing quality and efficiency, Chipset has identified reducing the delivery time to customers—the time between when customers order a product and when they receive it—as a critical component for achieving its cost-leadership strategy (some customers have complained about long waiting periods). We explore these different strategic components in the next section, where we look at how Chipset can effectively implement its strategy.