7 Powers
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Such reversals are rare in business, because contests typically take place over extended periods and with great thoughtfulness on all sides. Even a momentary lapse by an incumbent won’t present a sufficient opening. The only bet worthwhile for a challenger is one in which even if the incumbent plays its best game, it can be taken off the board. A competent Counter-Positioned challenger must take advantage of the strengths of the incumbent, as it is this strength which molds the Barrier, collateral damage.
Counter-Positioning Leverage
For Counter-Positioning, the Competitor Position element of Power is simply binary: you have adopted the heterodox business model. The Industry Economics aspect of Power refers to the central characteristics of this model: it must be superior, and it must cause the expectation of perceived collateral damage.
Figure 3.5: Power Intensity Determinants
Appendix 3.1: Derivation of Surplus Leader Margin for Counter-Positioning
To calibrate the intensity of Power, I ask the question “What governs profitability of the company with Power (S) when prices are such that the company with no Power (W) makes no profit at all?” In the case of Counter-Positioning (CP), the incumbent is W and the challenger is S.
Both business models are strictly variable cost: Profits ≡ π = (P – c) Q
With
P ≡ price per unit
c ≡ variable cost per unit
Q ≡ unit volume
There are two business models: Old ≡ O and New ≡ N
N’s superior business model => Nc < Oc; N cannibalizes O via NP < OP.
W faces the choice of whether to enter N or not.
Surplus leader margin (SLM) is the margin the company with Power can earn while pricing is such that the margin of the weaker firm is zero. SLM is an indicator of the intensity of Power. The surplus indicated (if positive) gives S the opportunity for profits and/or Power position enforcement. In the cases of Network Economies and Scale Economies, the scale leader is S, so SLM indicates retaliatory latitude in protecting market share. In the case of CP, S is the challenger, and Power position enforcement involves diminishing the likelihood that W, the incumbent, will enter N to battle S. Such enforcement involves increasing the collateral damage.
SLM in CP will be the S’s margin when the incremental profitability for W of deciding to enter N is zero.
For simplicity I will look at this as a single-period problem, although in the real world the businesses will likely be evaluating a number of periods.
So for collateral damage to just cancel out the gains to W from entering N:
Note that I will drop the W, S notation since collateral damage only refers to W’s economics.
So SLM > 0 combined with the earlier conditions of NP < OP and Nc < Oc characterize the Milk case of CP. Both a Benefit and a Barrier are evident.
Let me comment on the implications of this specification:
If ∆OQ = 0. This means that W anticipates that their entry into N will cause no additional volumes losses in their base business O. Then δ = 0.
This would result in SLM = 0 so there is no CP.
What is going on, of course, is that there is simply no collateral damage.
Thus a commonly observed behavior is that Counter-Positioned incumbents will seek customer segments in which they induce no additional loss of O customers by offering N.
For example, a Financial Times article of Oct. 24, 2015: Walt Disney’s most beloved characters and stories are going digital in a new streaming service that launches in the UK next month. DisneyLife bundles books and music with its animated and live action films, making Disney the biggest media company yet to stream its content directly to consumers online.
Disney will expand the service across Europe next year, with the goal of launching in France, Spain, Italy and Germany, and would add content as it becomes available, the company said.
…It has no plans to bring the service to the US, its biggest market, because of potential overlaps with the many agreements it has with cable and satellite companies that distribute its film and television content.
If δ < 1 (the unit gains in N are more than offset by the losses in O for W). CP is unlikely. For CP, the margins would have to be attractive enough in N to offset both the lower prices in N and the volume losses.
Thus the incumbent would need to anticipate volume gains in N which more than offset the cannibalization of O volume induced by their entry into N.
One of the ironies of CP is that the higher the incumbent’s margins, the higher the SLM. This of course simply reflects that W has more to lose by erosion of their O business. CP therefore can present a potent challenge to an entrenched highly successful incumbent.
The potential for cognitive bias (History’s Slave) can be usefully explored by noting the elements of the SLM equation. In considering entry into N, the incumbent will often exhibit a cognitive bias that raises their expected δ, and thus increases SLM. They have more certainty regarding ∆OQ than NQ so they often understate NQ. For example, someone within W who wishes to push ahead and enter N is often incented not to promise too much.
Thus this creates a cognitive skew toward CP.
The potential for agency effects (Job Security) can also be looked at through the lens of the SLM equation. Example 1. An important decision influencer is the division head responsible for the O business. The O business has been the corporation’s bread and butter, so this person’s voice carries a lot of weight.
However, the N business results are attributed to another division or group.
So using my example from this chapter, imagine that the active fund managers would get no credit for the assets under management in the newly formed passive funds, a quite realistic assumption.
This arrangement assures that NQ = 0 for this individual (group), and this means δ = ∞ assuring CP.
Example 2. At the CEO level, compensation may be set in a way that places emphasis on near-in results (this year, for example). Although I have used a single-period formulation in this appendix, the real calculation should be an NPV, and, as I have discussed, out years weigh heavily on this. The agency effects may lead to lower weights to these out years and, as I will discuss below, collateral damage tends to become less and less likely to be met as you go forward in time.
The reader should also keep in mind that the agency and cognitive effects in CP are not mutually exclusive with the Milk case. In fact, they are frequently additive: all three effects operating at the same time.
Dynamic effects As you move forward in time, δ tends to decline, reducing Power intensity (and perhaps eliminating CP altogether).
The reason for this is that as the aggregate cumulative cannibalization of O by N increases, NQ tends to go up because the opportunity overall for N is larger as it becomes proven and known, and |∆OQ| tends to go down as the expected loss in O business is seen to come primarily from the challenger’s incursions, rather than that induced by W’s entry into N.
Also the agency and cognitive skews toward fulfilling the collateral damage condition tend to diminish over time as the uncertainty surrounding the threat of N diminishes and the agents aligned with O in W tend to lose credibility and influence.
Since δ tends to decline, SLM declines and the collateral damage may be insufficient to deter W’s entry into N. This is the capitulation point mentioned in the chapter.
I understand that this specification is highly stylized. Even so, the future profit calculations in corporations tend not to be theoretically complex, so even this stylized representation may capture much of what is going on.
Tactically, it is probably a good idea for S to set prices at first such that Nm is very low—much lower than Om. Nm is usually observable by W as is NP, whereas δ is not.
So if [NP/OP] is quite small, then W has to be quite optimistic about a low cannibalization rate (δ) to lead to an SLM > 0 thus creating CP.
A special case is one in which S offers N at first for NP such that Nm <
0. This makes [Nm/Om] < 0 and assures the collateral damage condition is met for the periods of this pricing. Since NP is observed but S’s motivation is not, W may well discount the possibility that S will eventually raise prices such that Nm > 0 whereas S can know this, assuming they are a price leader.
C H A P T E R 4
SWITCHING COSTS
ADDICTION
Agony at HP
SAP is the world’s leading supplier of enterprise resource planning software (ERP). Users rely on this software to collect and analyze data essential for running a modern corporation: accounting data, sales tracking, manufacturing management and so on. Despite SAP’s success in ERP, the company is no poster-child for customer satisfaction. According to Geoff Scott, CEO of America’s SAP Users’ Group, “As a former CIO, one of the biggest and most consistent complaints I heard from my line of business partners was the complexity and difficulty of the SAP user experience.”32 A recent Compuware study33 of 588 SAP customers in Europe and the US found that 43% were unhappy with SAP response times across all components. Nearly all felt that SAP performance problems would result in financial risks, and 50% felt unable to predict SAP performance. Yet another survey34 of more than 1,000 customers found that 89% expected to continue paying the annual maintenance fees for SAP in the near future. Why would customers continue to pay for a product they so dislike? It seems as though the old adage “No one ever got fired for buying IBM” has been supplanted by “No one ever got fired for sticking with SAP.”
The explanation for this paradox lies in the Power type covered in this chapter: Switching Costs. A simple example is Apple’s hold on its iTunes customers. Apple downloads come in a proprietary format, so in switching to another program, Apple customers forfeit their prior purchases. This is an unattractive prospect, which accounts for why so many customers stay locked in.
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.
To illustrate the onerous Switching Costs a firm would have to worry about, consider what happened when Hewlett Packard migrated their North American server sales divisions ($7.5 billion revenue at the time) to SAP. This followed a corporate directive for an enterprise-wide ERP implementation, meaning the division had no choice but to bear the costs, whatever they might be.
Christina Hanger was Hewlett-Packard (HP)’s Senior Vice President of American Operations in May 2004.35 She was already an old hand at SAP migrations, having already overseen five of them at HP following their acquisition of Compaq, and this experience guided her budgeting: three weeks to accommodate changeover of the legacy order-entry system to the SAP system, plus three weeks of extra server inventory. Hanger also commandeered additional HP factory capacity in Omaha to accommodate unforeseen production demands that might arise during the switchover. Simply put: she was well prepared.
Even her careful preparation was insufficient, however.
Starting when the system went live at the beginning of June and continuing throughout the rest of the month, as many as 20 percent of customer orders for servers stopped dead in their tracks between the legacy order-entry system and the SAP system.36
HP was not the only company selling servers—customers could easily turn to Dell or IBM. So, as backlog piled up, HP started to lose business. In her conference call with analysts HP CEO Carly Fiorina later stated that this snafu resulted in a $160M financial hit. The HP experience perfectly exemplifies not only the high Switching Costs (considerably more than the software itself) an ERP migrator can expect, but also the intimidating uncertainty which surrounds the planning for such a migration.
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. The continued climb of SAP’s stock price, shown below in Figure 4.1, testifies to the vitality and endurance afforded by the business model born of such reliance.37
Figure 4.1: SAP Stock Price38
Switching Costs on the 7 Powers
Switching Costs arise when a consumer values compatibility across multiple purchases from a specific firm over time. These can include repeat purchases of the same product or purchases of complementary goods.39
Benefit. A company that has embedded Switching Costs for its current customers can charge higher prices than competitors for equivalent products or services.40 This benefit only accrues to the Power holder in selling follow-on products to their current customers; they hold no Benefit with potential customers and there is no Benefit if there are no follow-on products.
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. Thus, as with Scale Economies and Network Economies, the Barrier arises from the unattractive cost/benefit of share gains for the challenger.
With this understanding, I can now place Switching Costs on the 7 Powers Chart:
Figure 4.2: Switching Costs in the 7 Powers
Switching Costs definition:
The value loss expected by a customer that would be incurred from switching to an alternate supplier for additional purchases.
Types of Switching Costs
Switching Costs can be divided into three broad groups:42
Financial. Financial Switching Costs include those which are transparently monetary from the outset. For ERP, these would include the purchase of both a new database and the sum total of its complementary applications.
Procedural. Procedural Switching Costs are somewhat murkier but no less persuasive. They stem from the loss of familiarity with the product or from the the risk and uncertainty associated with the adoption of a new product. When employees have invested time and effort to learn the particulars of how to use a certain product, there can be a significant cost to retraining them in a different system. In the case of SAP, applications exist for a wide array of enterprise functions. This means that there are employees in human resources, sales and marketing, procurement, accounting, not to mention managers across these many divisions, who have all learned how to create reports based on the SAP system and its complementary software. Such a system-switch breeds organizational discontent by forcing many within the ranks of the organization to change their daily routines.
Furthermore, procedural changes open the door for errors. With databases, these are particularly costly, since they involve the totality of the customer’s information. Even when a competitor provides services and programs to help mitigate such difficulties of transition, these often prove costly and imperfect.
Relational. Relational Switching Costs are those tolls which would result from the breaking of emotional bonds built up through use of the product and through interactions with other users and service providers. Often a customer establishes close, beneficial relationships with the provider’s sales and service teams. Such familiarity, ease of communication
and mutual positive feelings can create resistance to the prospect of severing those ties and switching to another vendor. Additionally, if the customer has developed affection for the product and their identity as a user, or if they enjoy the camaraderie which exists amongst a community of like users, they may shrink from the prospect of switching identities and abandoning that community.43
Switching Costs Multipliers
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.
Switching Costs offer no Benefit if no additional related sales are made to the customer. To assure that such additional sales take place, one tactic might be to develop more and more add-on products. This has been SAP’s tack, as seen from this Wikipedia list of the company’s offerings.45
Figure 4.3: SAP Product Offerings46
Acquisitions significantly accelerate product line extensions, too, serving as a sort of outsourced development. This too has been part of SAP’s playbook, as proven by their ambitious acquisition program.47