7 Powers: The Foundations of Business Strategy

by Hamilton Wright Helmer

Exclusive rights and originals made content, a major component of Netflix’s cost structure, a fixed-cost item. Any potential streamer would now have to ante up the same number of dollars, regardless of how many subscribers they had. If, say, Netflix paid $100M for House of Cards and their streaming business had 30M customers, then the cost per customer was three dollars and change. In this scenario, a competitor with only one million subscribers would have to ante up $100 per subscriber. This was a radical change in industry economics, and it put to rest the specter of a value-destroying commodity rat race.

The quality of declining unit costs with increased business size is referred to as Scale Economies.

For Scale Economies, the Benefit is straightforward: lowered costs. In the case of Netflix, their lead in subscribers translated directly in lower content costs per subscriber for originals and exclusives.

The Barrier, however, is subtler. What prevents other firms from competing this away? The answer lies in the likely interplay of well-managed competitors. Suppose a company has a significant scale advantage in a Scale Economies business. Smaller firms would spot this advantage, and their first impulse might be to pick up market share, thus improving their relative cost position and erasing some of this disadvantage while improving their bottom line. To get there, however, they would have to offer up better value to customers, such as lower prices. In an established market, such tactics are visible to the leader, who would realize the threat of reducing their relative scale advantage; they would retaliate by using their superior cost position as a defensive redoubt (matching price cuts for example). After several bouts of this, a follower will come to expect such retaliation and build it into their financial models for the impact of gain-share moves. For them, such moves would inevitably destroy value, rather than create it.

This situation creates a very difficult position for Netflix’s smaller-scale streaming competitors. If they offer the same deliverable as Netflix, similar amounts of content for the same price, their P&L will suffer. If they try to remediate this by offering less content or raising prices, customers will abandon their service and they will lose market share. Such a competitive cul-de-sac is the hallmark of Power.

With regard to the Benefit, cash flow is improved by (1) enhancing value (enabling higher pricing) and/or (2) lowering cost ceteris paribus.17 With regard to the Barrier, a competitor fails to arbitrage out the Benefit because (1) they are unable to, or (2) they can, but refrain from so doing because they expect the outcome to be

economically unattractive.

Here let’s define Scale Economies: A business in which per unit cost declines as production volume increases.

Beyond fixed costs, Scale Economies emerge from other sources as well. To name a few:

Volume/area relationships. These occur when production costs are closely tied to area, while their utility is tied to volume, resulting in lower per-volume costs with increasing scale. Bulk milk tanks and warehouses would serve as examples.

Distribution network density. As the density of a distribution network increases to accommodate more customers per area, delivery costs decline as more econo...

Learning economies. If learning leads to a benefit (reduced cost or improved deliverables) and is positively correlated with production levels, then a scale advantage accrues to the leader.

Purchasing economies. A larger scale buyer can often elicit better pricing for inputs. For example, this has helped Wal-Mart.

Recruiters want to make the best use of their time, so they go to the source with the largest number of listed professionals, while at the same time professionals want to list their names on the site with the most recruiters visiting. Such one-hand-shakes-the-other self-reinforcing upward spirals are known as Network Economies22: the value of the service to each customer is enhanced as new customers join the “network.” In such a situation, having the most customers is everything, and Marini knew exactly how this game was played: rapidly scale or die.

Network Economies occur when the value of a product to a customer is increased by the use of the product by others.

Benefit. A company in a leadership position with Network Economies can charge higher prices than its competitors, because of the higher value as a result of more users.

Barrier. The barrier for Network Economies is the unattractive cost/benefit of gaining share, and this can be extremely high. In particular the value deficit of a follower can be so large that the price discount needed to offset this is unthinkable.

Network Economies definition: A business in which the value realized by a customer increases as the installed base increases.

Benefit. The new business model is superior to the incumbent’s model due to lower costs and/or the ability to charge higher prices.

The Barrier, simply put, is collateral damage. In the Vanguard case, Fidelity looked at their highly attractive active management franchise and concluded that the new passive funds’ more modest returns would likely fail to offset the damage done by a migration from their flagship products.

Counter-Positioning is not an exclusive source of Power. The two prior chapters covered Power types that were exclusive: there

could be only one company with Power.

While competitors poured flames on our market share, what happened at Nokia? We fell behind, we missed big trends, and we lost time. At that time, we thought we were making the right decisions; but, with the benefit of hindsight, we now find ourselves years behind. The first iPhone shipped in 2007, and we still don’t have a product that is close to their experience. Android came on the scene just over 2 years ago, and this week they took our leadership position in smartphone volumes. Unbelievable. — Stephen Elop, Nokia CEO

The explanation for this paradox lies in the Power type covered in this chapter: Switching Costs.

The ERP model offers a more complex and larger-scale illustration. The decision to replace any ERP carries high cost. Once ERP is integrated into a client’s business, employees have sunk the cost of learning to use this system, relationships have been established with the new service team to solve problems, and investments have been made in compatible software to customize the system to the client’s needs. Once done, changing that only comes at an extraordinarily high cost: the time and effort to research competitive offerings, the purchase cost of a replacement ERP system, all the complementary software, transferring the data, retraining employees, forming new relationships, and risking interruption of services and loss of data during the transition from one system to another.

SAP’s paradoxical combination of high retention and low satisfaction reflects the economic reality of a software product of great value to a corporation but one that also comes with high Switching Costs. Once a customer has bought in, they are hopelessly hooked, enabling SAP to then reap the rewards of a future stream of revenues for annual maintenance charges, upgrades, add-on services, software and consulting. More, a company like SAP, profiting from the indenture of its clients, has all incentive to hike the prices of such services.

Benefit. A company that has embedded Switching Costs for its current customers can charge higher prices than competitors for equivalent products or services.

Barrier. To offer an equivalent product,41 competitors must compensate customers for Switching Costs. The firm that has previously roped in the customer, then, can set or adjust prices in a way that puts their potential rival at a cost disadvantage, rendering such a challenge distinctly unattractive.

Switching Costs definition: The value loss expected by a customer that would be incurred from switching to an alternate supplier for additional purchases.

Switching Costs are a non-exclusive Power type: all players can enjoy their benefits. IBM and Oracle are competitors to SAP, and they also benefit from high customer retention rates and Switching Costs. As a market matures, the Benefit of Switching Costs becomes transparent to all players and they are able to calculate the value of an acquired customer. More often than not this leads to enhanced competition to grab new customers, which arbitrages out the Benefit for new customer acquisitions.44 So the major value contribution comes from capturing customers before such value-destroying pricing arbitrage transpires.

In 2005, Good Morning America purchased a diamond ring at Tiffany & Co. for $16,600 and one of similar size and cut at Costco for $6,600. They then asked Martin Fuller, a reputable gemologist and appraiser, to assess the rings’ values. Fuller assessed the Costco ring at $8,000 plus setting costs, more than $2,000 above the selling price. “It’s a little bit of a surprise. You wouldn’t normally consider a fine diamond to be found in a general store like Costco….”49 Fuller assessed the Tiffany ring at $10,500 plus setting costs at a non-brand-name retailer.

Tiffany’s success is evidenced by the fact that, although the Blue Box comes free with a purchase, it carries a standalone monetary value.

Tiffany’s Power lies in Branding. Branding is an asset that communicates information and evokes positive emotions in the customer, leading to an increased willingness to pay for the product.

Benefit. A business with Branding is able to charge a higher price for its offering due to one or both of these two reasons:

Affective valence. The built-up associations with the brand elicit good feelings about the offering, distinct from the objective value of the good. For example, Safeway’s cola may be indistinguisha...

revealing the result, the taste tester remains willing to...

Uncertainty reduction. A customer attains “peace of mind” knowing that the branded product will be as just as expected. Consi...

Barrier. A strong brand can only be created over a lengthy period of reinforcing actions (hysteresis), which itself serves as the key Barrier. Again, Tiffany has cultivated its brand name for more than a century. What’s more, copycats face daunting uncertainty in initiating Branding: a long investment runway with no assurance of an eventual path to significant affective valence.

Branding definition: The durable attribution of higher value to an objectively identical offering that arises from historical information about the seller.

Seeking higher “down market” volumes can reduce affective valence by damaging the aura of exclusivity, weakening positive associations with the product. For example, Halston rose to fame in the 1970s as a high-end design standard for women’s clothing. However, when Halston accepted $1 billion from lower-end retailer J.C. Penney to expand into affordable fashion lines for the mass consumer, Bergdorf Goodman dropped the label in order to protect their brand. The J.C. Penney line was a failure, and the Halston name never recaptured its previously enviable Branding.

Counterfeiting. Since it is the label, not the product, that bestows Branding Power, counterfeiters may try to free-ride by falsely associating a powerful brand with their product.

Type of Good. Only certain types of goods have Branding potential (more on this in the Appendix on Surplus Leader Margin) as they must clear two conditions:

Magnitude: the promise of eventually justifying a significant price premium.

Consumer goods, in particular those associated with a sense of identity, tend to have the purchasing decision more driven by affective valence.

For Branding Power derived from uncertainty reduction, the customer’s higher willingness to pay is driven by high perceived costs of uncertainty relative to the cost of the good. Such products tend to be those associated with bad tail events: safety, medicine, food, transport, etc. Branded medicine formulations, for example, are identical to those of generics, yet garner a significantly higher price.

Duration: a long enough amount of time to achieve such magnitude. If the requisite duration is not present, the Benefit attained will fall prey to normal arbitraging behavior.

This Power type is given a name in Economics: Cornered Resource. The services of this cohesive group of talented, battle-hardened veterans were

available only to Pixar; they had it cornered.

Benefit. In the Pixar case, this resource produced an uncommonly appealing product—“superior deliverables”—driving demand with very attractive price/volume combinations in the form of huge box office returns.

In other instances, however, the Cornered Resource can emerge in varied forms, offering uniquely different benefits. It might, for example, be preferential access to a valuable patent, such as that for a blockbuster drug; a required input, such as a cement producer’s ownership of a nearby limestone source, or a cost-saving production manufacturing approach, such as Bausch and Lomb’s spin casting technology for soft contact lenses.