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the industry, such as IBM, Compaq, Dell, and Apple, reported poor performance in the
early 1990s and were forced to undergo internal restructuring. What accounted for this
low pro¬tability? What was the computer industry™s future pro¬t potential?

very intense for a number of reasons:
• The industry was fragmented, with many firms producing virtually identical prod-
ucts. Even though the computer market became more concentrated in the 1990s,
with the top five vendors controlling close to 60 percent of the market, competition
was intense, leading to routine price cuts on a monthly basis.
• Component costs accounted for more than 60 percent of total hardware costs of a
personal computer, and volume purchases of components reduced these costs.
Therefore, there was intense competition for market share among competing man-
• Products produced by different firms in the industry were virtually identical, and
there were few opportunities to differentiate the products. While brand name and
service were dimensions that customers valued in the early years of the industry,
they became less important as PC buyers became more informed about the
• Switching costs across different brands of personal computers were relatively low
because a vast majority of the personal computers used Intel microprocessors and
Microsoft Windows operating systems.
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Strategy Analysis

• Access to distribution was not a significant barrier, as demonstrated by Dell Com-
puters, which distributed its computers by direct mail through the 1980s and intro-
duced Internet-based sales in the mid-1990s. The advent of computer superstores
like CompUSA also mitigated this constraint, since these stores were willing to car-
ry several brands.
• Since virtually all the components needed to produce a personal computer were
available for purchase, there were very few barriers to entering the industry. In fact,
Michael Dell started Dell Computer Company in the early 1980s by assembling
PCs in his University of Texas dormitory room.
• Apple™s Macintosh computers offered competition as a substitute product. Work-
stations produced by Sun and other vendors were also potential substitutes at the
higher end of the personal computer market.

THE POWER OF SUPPLIERS AND BUYERS. Suppliers and buyers had signi¬cant
power over ¬rms in the industry for these reasons:
• Key hardware and software components for personal computers were controlled by
firms with virtual monopoly. Intel dominated the microprocessor production for the
personal computer industry, and Microsoft controlled the operating system market
with its DOS and Windows operating systems.
• Buyers gained more power during the ten years from 1983 to 1993. Corporate buy-
ers, who represented a significant portion of the customer base, were highly price
sensitive since the expenditure on PCs represented a significant cost to their oper-
ations. Further, as they became knowledgeable about personal computer technol-
ogy, customers were less influenced by brand name in their purchase decision.
Buyers increasingly viewed PCs as commodities, and used price as the most impor-
tant consideration in their buying decision.
As a result of the intense rivalry and low barriers to entry in the personal computer
industry, there was severe price competition among different manufacturers. Further,
there was tremendous pressure on ¬rms to spend large sums of money to introduce new
products rapidly, maintain high quality, and provide excellent customer support. Both
these factors led to a low pro¬t potential in the industry. The power of suppliers and buy-
ers reduced the pro¬t potential further. Thus, while the personal computer industry rep-
resented a technologically dynamic industry, its pro¬t potential was poor.
There were few indications of change in the basic structure of the personal computer
industry, and there was little likelihood of viable competition emerging to challenge the
domination of Microsoft and Intel in the input markets. Attempts by industry leaders like
IBM to create alternative proprietary technologies have not succeeded. As a result, the
pro¬tability of the PC industry may not improve signi¬cantly any time in the near future.

LIMITATIONS OF INDUSTRY ANALYSIS. A potential limitation of the industry
analysis framework discussed in this chapter is the assumption that industries have clear
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2-9 Part 2 Business Analysis and Valuation Tools

boundaries. In reality, it is often not easy to clearly demarcate industry boundaries. For
example, in analyzing Dell™s industry, should one focus on the IBM-compatible personal
computer industry or the personal computer industry as a whole? Should one include
workstations in the industry de¬nition? Should one consider only the domestic manu-
facturers of personal computers, or also manufacturers abroad? Inappropriate industry
de¬nition will result in incomplete analysis and inaccurate forecasts.

The pro¬tability of a ¬rm is in¬‚uenced not only by its industry structure but also by the
strategic choices it makes in positioning itself in the industry. While there are many ways
to characterize a ¬rm™s business strategy, as Figure 2-2 shows, there are two generic
competitive strategies: (1) cost leadership and (2) differentiation.8 Both these strategies
can potentially allow a ¬rm to build a sustainable competitive advantage.

Figure 2-2 Strategies for Creating Competitive Advantage

Cost Leadership Differentiation

Supply same product or service Supply a unique product or ser-
at a lower cost. vice at a cost lower than the
price premium customers will
Economies of scale and scope
Ef¬cient production
Simpler product designs Superior product quality
Lower input costs Superior product variety
Low-cost distribution Superior customer service
Little research and development or More ¬‚exible delivery
brand advertising Investment in brand image
Tight cost control system Investment in research and
Control system focus on creativity
and innovation

Competitive Advantage
• Match between ¬rm™s core competencies and key success
factors to execute strategy
• Match between ¬rm™s value chain and activities required
to execute strategy
• Sustainability of competitive advantage
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Strategy researchers have traditionally viewed cost leadership and differentiation as
mutually exclusive strategies. Firms that straddle the two strategies are considered to be
“stuck in the middle” and are expected to earn low pro¬tability.9 These ¬rms run the risk
of not being able to attract price conscious customers because their costs are too high;
they are also unable to provide adequate differentiation to attract premium price cus-

Cost leadership enables a ¬rm to supply the same product or service offered by its com-
petitors at a lower cost. Differentiation strategy involves providing a product or service
that is distinct in some important respect valued by the customer. For example, in retail-
ing, Nordstrom has succeeded on the basis of differentiation by emphasizing exception-
ally high customer service. In contrast, Filene™s Basement Stores is a discount retailer
competing purely on a low-cost basis.

Competitive Strategy 1: Cost Leadership
Cost leadership is often the clearest way to achieve competitive advantage. In industries
where the basic product or service is a commodity, cost leadership might be the only way
to achieve superior performance. There are many ways to achieve cost leadership, in-
cluding economies of scale and scope, economies of learning, ef¬cient production, sim-
pler product design, lower input costs, and ef¬cient organizational processes. If a ¬rm
can achieve cost leadership, then it will be able to earn above-average pro¬tability by
merely charging the same price as its rivals. Conversely, a cost leader can force its com-
petitors to cut prices and accept lower returns, or to exit the industry.
Firms that achieve cost leadership focus on tight cost controls. They make invest-
ments in ef¬cient scale plants, focus on product designs that reduce manufacturing
costs, minimize overhead costs, make little investment in risky research and develop-
ment, and avoid serving marginal customers. They have organizational structures and
control systems that focus on cost control.

Competitive Strategy 2: Differentiation
A ¬rm following the differentiation strategy seeks to be unique in its industry along
some dimension that is highly valued by customers. For differentiation to be successful,
the ¬rm has to accomplish three things. First, it needs to identify one or more attributes
of a product or service that customers value. Second, it has to position itself to meet the
chosen customer need in a unique manner. Finally, the ¬rm has to achieve differentiation
at a cost that is lower than the price the customer is willing to pay for the differentiated
product or service.
Strategy Analysis

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Drivers of differentiation include providing superior intrinsic value via product qual-
ity, product variety, bundled services, or delivery timing. Differentiation can also be
achieved by investing in signals of value, such as brand image, product appearance, or
reputation. Differentiated strategies require investments in research and development,
engineering skills, and marketing capabilities. The organizational structures and control
systems in ¬rms with differentiation strategies need to foster creativity and innovation.
While successful ¬rms choose between cost leadership and differentiation, they can-
not completely ignore the dimension on which they are not primarily competing. Firms
that target differentiation still need to focus on costs, so that the differentiation can be
achieved at an acceptable cost. Similarly, cost leaders cannot compete unless they
achieve at least a minimum level on key dimensions on which competitors might differ-
entiate, such as quality and service.

The choice of competitive strategy does not automatically lead to the achievement of
competitive advantage. To achieve competitive advantage, the ¬rm has to have the capa-
bilities needed to implement and sustain the chosen strategy. Both cost leadership and
differentiation strategy require that the ¬rm make the necessary commitments to acquire
the core competencies needed, and structure its value chain in an appropriate way. Core
competencies are the economic assets that the ¬rm possesses, whereas the value chain
is the set of activities that the ¬rm performs to convert inputs into outputs. The unique-
ness of a ¬rm™s core competencies and its value chain and the extent to which it is dif¬-
cult for competitors to imitate them determines the sustainability of a ¬rm™s competitive
To evaluate whether or not a ¬rm is likely to achieve its intended competitive advan-
tage, the analyst should ask the following questions:
• What are the key success factors and risks associated with the firm™s chosen com-
petitive strategy?
• Does the firm currently have the resources and capabilities to deal with the key suc-
cess factors and risks?
• Has the firm made irreversible commitments to bridge the gap between its current
capabilities and the requirements to achieve its competitive advantage?
• Has the firm structured its activities (such as research and development, design,
manufacturing, marketing and distribution, and support activities) in a way that is
consistent with its competitive strategy?
• Is the company™s competitive advantage sustainable? Are there any barriers that
make imitation of the firm™s strategy difficult?
• Are there any potential changes in the firm™s industry structure (such as new tech-
nologies, foreign competition, changes in regulation, changes in customer require-
ments) that might dissipate the firm™s competitive advantage? Is the company
flexible enough to address these changes?
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Strategy Analysis

Let us consider the concepts of competitive strategy analysis in the context of Dell Com-
puter Corporation. In 1998 Round Rock, Texas-based Dell Computer was the fourth
largest computer maker, behind IBM, Hewlett-Packard, and Compaq. The company,
founded by Michael Dell in his University of Texas dorm room, started selling “IBM
clone” personal computers in 1984. From the beginning, Dell sold its machines directly
to end users, rather than through retail outlets, at a signi¬cantly lower price than its com-
After rapid growth and some management hiccups, Dell ¬rmly established itself in
the personal computer industry by following a low cost strategy. By 1998 Dell achieved
$18 billion in revenues and $1.5 billion in net income. Dell™s growth rates over the pre-
vious three years were extraordinary: 51 percent growth in revenues, and 78 percent
growth in net income. Dell™s stellar performance made it one of the most pro¬table per-
sonal computer makers in a highly competitive industry. How did Dell achieve such per-
Dell™s superior performance was based on a low-cost competitive strategy that con-
sisted of the following key elements:
• Direct selling. Dell sold most of its computers directly to its customers, thus saving
on retail markups. As computer users become sophisticated, and as computers be-
come standardized on the Windows-Intel platform, the value of distribution
through retailers declines. Dell was the first company to capitalize on this trend. In
1996 Dell began selling computers through its Internet web site. By 1999 the com-
pany was generating several million dollars of sales per day through the Internet.
• Made-to-order manufacturing. Dell developed a system of flexible manufacturing


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