The competitive advantage is the capacity of a company to produce goods or services better, or more cheaply, than its competitors, allowing the company to generate more sales or have higher margins. Competitive advantage derives from the combination of ten sources: five of them allow companies to charge a price premium, four of them contribute to cost and capital efficiency, and the final one combines price and cost advantages to produce increasing returns to scale.
Price premium advantages
To sell its products at a price premium, a company must differentiate its products from those of competitors. The price premium advantages are innovative products, quality, brand, customer lock-in, and rational price discipline.
Innovative products and services yield high returns on capital if they are protected by patents or are difficult to copy. An example of an innovative product line that is difficult to copy was Apple’s iPod MP3 players: indeed, the iPod was more successful than other MP3 players because of its appealing design and ease of use thanks to its user interface and integration with iTunes. Apple followed a similar approach with the iPhone and iPad, and, once again, the design and the user interface were core drivers of the price premium. Although not patent protected, good design can be difficult to copy.
In the context of competitive advantage and return on invested capital, quality means a real or perceived difference between one product or service, and another for which consumers are willing to pay a higher price. In the car business, for example, Tesla enjoys a price premium because customers perceive that the product is better than other automobiles that cost less. Therefore, Tesla has often been able to earn higher returns than many other carmakers.
While the quality of a product may matter more than its established branding, sometimes the brand itself is what matters more, especially when it has lasted a very long time. For example, in some categories of products, customers are loyal to brands like Coca-Cola, Pepsi, Procter & Gamble and Kellogg’s despite the availability of high quality branded and private-label alternatives.
When replacing one company’s product or service with another is relatively expensive for customers, the company can charge a price premium. For example, Procter & Gamble’s Gillette, which sells shaving products, realizes its margin not on the starter pack but on replacement razor blades.
Finally, the last source of price premium is the rational price discipline. In commodity industries with many competitors, the laws of supply and demand drives down prices and return on capital. The same happens in other service or product industries, such as the airline one. Indeed, each competitor is tempted to get an edge in filling seats by keeping prices low, even when fuel prices and other costs rise. However, while the airline sector in the United States has rapidly consolidated and become more cautious about adding seat capacity, most European airlines have faced strong price competition, thus lowering their returns on capital.
Cost and capital efficiency advantages
Cost and capital efficiency can be considered two separate competitive advantages: the first is the ability to deliver products and services at a lower cost, the second is about delivering more products per dollar of invested capital than competitors. However, both tend to share common drivers which are hard to separate.
The majority of production methods can be copied, however there are few exceptions. For example, IKEA transformed the home furniture business, driving innovations from design to manufacturing, and from distribution to sales. Its concept of self-assembly furniture reduces production and storage costs, manufacturing and development costs, and, most importantly, time. Its automated distribution centers are highly efficient because its product meets standard packaging requirements, and all its retail stores are highly standardized too, giving the company an edge over all of its competitors.
Often, a company has access to unique resources that other competitors cannot replicate, providing a significant competitive advantage. For example, gold miners in North America earn higher returns than those in South Africa because the northern ore is closer to the surface, making the extractions easier and cheaper. In general, when the cost of shipping a product is high relative to its value, producers that are geographically near their customers have a unique advantage.
Scale can be important an important factor to consider too, but usually only at the regional or local level. For example, a key element that determines the profitability of health insurers in the United States is their ability to negotiate prices with providers such as hospitals and doctors, who tend to operate locally rather than nationally. Therefore, the insurer with the highest market share in a local market will be in a position to negotiate the lowest prices, so it’s better to be the number-one in ten states than to have number-one market share nationwide but number four in every state.
Having scalable products or services means that the cost of supplying or serving additional customers is very low at all levels of scale. For example, once a software is developed, it can be sold to many customers with no incremental development costs. Other examples of scalable businesses include media and streaming companies that make and distribute movies or TV shows: making the movie or show requires an initial investment for the crew, sets, actors, and so on, but those costs are fixed regardless of how many people end up viewing and paying for the show.
Network Economies
Some scalable business models provide higher returns on capital because they have network economies that lead to increasing returns to scale. As the business gains customers and grows, the cost of offering the products decreases, and their value to customers increases. Microsoft’s Office software benefits from scalable operations on the cost side because it can supply online products and services at extremely low marginal cost, but has also become more valuable as the customer base has expanded over time. Therefore, Microsoft has been able to lock in customers who want to easily exchange documents with other Office users and who don’t want to spend time switching to alternative software.
Conclusion
The competitive advantage drawn from these ten sources is enjoyed by particular business units and product lines. Indeed, every company may have individual businesses and product lines with very different degrees of competitive advantage and, thus, different returns on invested capital. Also, the businesses or products with the highest returns are often those that have more than one advantage.
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