The watch that revived an entire industry

New dynamics  of strategy in the  knowledge economy   W. Chan Kim and Renée Mauborgne     Summary Vast new opportunities, as well as threats, are opening  up as economies move from traditional "production" to a new model based on knowledge working, say W. Chan Kim and Renée Mauborgne.  One is the potential for earning vastly increased returns;  the other is the new potential for free-riding as new ideas are copied.  The authors explain why successful "value innovators" reject conventional market practice, and follow a new dynamic of strategy.  They expand demand through strategic pricing, and improve their profits by focusing on target costs.

Despite the current passion for mergers and acquisitions, the companies that are creating much of the new wealth, jobs and excitement are not those obsessed by getting bigger.  They are those that challenge how existing businesses run and offer entirely new ways of thinking about an industry. 

This applies not only in high-tech fields such as computers, software, and the internet where the likes of Microsoft, Intel, Cisco, Yahoo! and Dell are reaching new innovative heights.  In other industrial sectors the ability to develop new business models extends to retailers like Wal-Mart, airlines like Southwest, home repair chains like Home Depot, coffee shops like Starbucks, brokers like Charles Schwab, and bookstores like Borders and Amazon.com. 

For four years running, Fortune magazine has ranked Enron, the Houston-based energy company that operates in two of the oldest industries in the world -gas and electricity - as the most innovative company in the US.  Today Enron has as many traders, analysts, and rocket scientists - including a genuine ex-rocket scientist from the former Soviet Union - at its headquarters as it does gas and pipeline people.  Enron exemplifies the transition from the production to the knowledge economy in which the proportion and value of ideas and innovation to land, labour, and capital is rising dramatically even in the most basic industries. 
 

Knowledge economy risks
This switch from production to knowledge economy has two consequences. 

• it creates the potential for increasing returns.  This can be seen in software where, for example, production of the first copy of Windows 95 cost Microsoft millions, while subsequent copies cost no more than the near trivial price of a diskette.  It is also evident in businesses as capital intensive as Enron's.  Here for example the fixed costs of developing sophisticated financial risk management tools for hedging gas prices can be spread across infinite transactions at insignificant marginal cost.

• it creates enormous potential for free-riding.  This has to do with the non-rival and only partially excludable nature of knowledge.

In contrast, use of a non-rival good by one company in no way limits its use by another.  Ideas fall into this camp.  Thus when Chrysler's innovation in minivans took off in 1983, other car companies were able to make use of the concept without in any way limiting Chrysler's ability to apply it at the same time.  This makes competitive imitation not only possible, but less costly -- the cost and risk of developing the innovative idea is borne by the value innovator, not the follower. 

This challenge is exacerbated when the notion of excludability is considered.  Excludability is a function of both the nature of the good and the legal system.  A good is excludable if the company can prevent others from using it due, for example, to limited access or patent protection.  So, for example, Intel can exclude other microprocessor chip-makers from using its manufacturing facilities through property ownership laws.  And Starbucks can prevent other coffee chain start-ups from using its coffee beans by refusing to sell them to would-be copycats, i.e., strategically limiting access.  However, what Starbucks cannot exclude from others is their ability to walk into any store, study its layout, atmosphere, and product range, and mimic the 'idea' or 'blueprint' for a chic coffee bar concept.  Thus the highest value-added element of the Starbucks formula is not excludable.  Once ideas are 'out there,' there is a natural knowledge spillover which all companies can learn from.  This lack of excludability reinforces the risk of free-riding. 

Of course, were it possible to get a patent and formal legal protection for innovative ideas the risk would be considerably lower.  Pharmaceutical companies, for example, have long enjoyed the benefit of formal patent protection to prevent the free-riding of other drug companies on their scientific discoveries for a specified period.  But, how do you get a patent for a radically superior coffee store design concept like Starbucks, which has tremendous value but in itself comprises no new technological discoveries?  It is the arrangement of the items that fundamentally adds new value, i.e., the way they are combined, not the items themselves.  There is no black magic in making exotic coffee drinks, high quality coffee beans are purchasable from multiple sources, placing chairs and tables in corner store outlets is easy enough, as is having stacks of free newspapers to read and nice background music with friendly sales staff to help.  As with Body Shop, the UK cosmetics retailer, Home Depot, Charles Schwab, Virgin Atlantic Airways, Amazon.com, Borders and Barnes & Noble, and Chrysler's minivan (imitated in Europe as the MPV or people mover) the Starbucks story is about value innovation.  All offer buyers fundamentally new and superior value in traditional businesses through innovative ideas and knowledge. 

Even value innovations in software face the risk of free-riding.  While companies that write computer software can obtain copyrights that prohibit other companies from copying the specific coding in the program, the look, feel, and functionality of software is hardly patentable.  This means effectively, that any successful program can be copied.  Competing companies need only write their own code, but what functionality the software is to perform, how the internal programming components should be structured, and how the software should look and feel to customers can all, as Netscape painfully learned, be imitated.  The same can be said for Wal-Mart's valuable inventory replenishment system. 
 

Maximising returns
The question then is how best to maximise rents from value innovation ideas that have the potential for both increasing returns and free-riding.  Should value innovators follow the conventional practice of technology innovators that price high, limit access, and initially engage in price skimming to earn a premium on their innovation and only with the passage of time focus on lowering price and costs to hold ground and discourage imitators?  In most cases, the answer is no.  The dynamics of competition fundamentally change. 

In a world of non-rival and non-excludable goods subject to the potential of not only economies of scale and learning but also of increasing returns, volume becomes key, price becomes key, and hence cost becomes key in ways never seen before.  The aim from the outset is to capture the mass of buyers and expand the size of the market by offering radically superior value at price points accessible to the mass of buyers.  Hence, Amazon.com's strategy, summarised by founder Jeff Bezos, as "GBF" or "Get Big Fast." 

We expect then that value innovators should not follow the theory and practice of rent maximisation behaviour used by conventional innovators, for two reasons: 

Firstly because a high price premium and restricted supply provides a huge incentive for others to act on the opportunity of free-riding and undercut the price of the innovator. 

Secondly because pricing high and limiting volume in the interests of an image of exclusivity prevents the innovator from exploiting economies of scale, learning and increasing returns thereby defeating the innate profit advantage of "knowledge-heavy" goods. 

Indeed, we see successful value innovators follow a market approach distinct from that of the conventional monopolists. 

This involves: 

• Strategic pricing for demand creation;
• Target costing for profit creation.

Consider for example how Nicholas Hayek, the Chairman of Swatch group (formerly known as SMH) used this market approach to launch the Swatch, a value innovation which revived the entire Swiss watch industry. 

Swatch transformed the perception of a watch.  It moved from being a functional time-telling device to a fashion accessory embodying the joy of life.  It combined punctuality, endless new designs, a powerful emotional message, and artwork into an innovative concept for a watch. 

To capture the rents of this value innovation, Hayek set up a project team to determine Swatch's strategic launch price.  At the time the arrival of hundreds of cheap but high precision quartz watches from Japan and Hong Kong, were capturing a substantial part of the market.  These watches sold for up o $75.  To pull the mass of buyers, create new demand, an build a strong and rapid brand name, SMH aggressively set the price at $40. 

This price would not only motivate customers to buy several Swatches, just as people do with other fashion accessories like clothes, hats, coats or hair ribbons, but the price left scant if any room for Japanese or Hong Kong-based companies to copy and respond. 

The directive to the project team was:  the watch must sell for that price, not a penny more.  The team then worked backwards to arrive at target cost.  This involved working out what margin SMH needed to earn to support promotion and advertising.  The project team was then charged with devising a production system that could make Swatch at that cost and still earn the required profit margin.  The result was that SMH was driven to innovate through automation of its design of Swatch mechanics, production and assembly.  This led to an unbeatable cost structure in the world-wide watch industry. 

The price, cost, and volume dynamics of value innovation like Swatch can be graphically seen in the following attached Figure.  Value innovation radically increases the appeal of a good, shifting the demand curve from D1 to D2.  However, recognising the non-rival and only partially excludable nature of its innovative good, the value innovator strategically prices the product from the outset to capture the mass of buyers in the expanded market.  In the Swatch case this meant shifting the price from P1 to P2.  This increases the quantity sold from Q1 to Q2 and builds strong brand recognition for unprecedented value.  The value innovator, however, engages in target costing simultaneously to reduce the long-run average cost curve from LRAC1 to LRAC2 to expand its ability to profit and discourage free-riding and imitation. 

Buyers receive a quantum leap in value, shifting the consumer surplus from axb to eyf.  And the value innovator earns a leap in profit and growth, shifting the profit zone from abcd to efgh.  The rapid brand recognition built by the value innovator as a result of the unprecedented value offered in the marketplace combined with a simultaneous drive to reduce costs allows companies to leapfrog the competition as economies of scale, learning, and increasing returns kick in.  Hence, the emergence of category killers and winner-take-most markets where companies earn dominant positions while customers simultaneously come out big winners. 

While value innovators do not always exercise low strategic pricing as in the case of Swatch, their market approach in pulling the mass of buyers is in many respects, at odds with conventional monopolists.  The extent to which the idea behind a value innovation is non-excludable has a bearing on the level of strategic price set by the value innovator.  While, as we have argued, innovative ideas and processes are usually non-excludable or partially so, there are also value innovators whose ideas are patentable and hence excludable for a given time length. 

In such cases value innovators may be inclined to set the strategic price of their product at the same level as or even above rivals' products and services.  However, recognising the powerful economies of scale, learning and increasing returns that come with high volumes of knowledge-heavy goods, the strategic price will still be set from the outset with the aim of capturing the mass of buyers. 

Dyson Appliances, for example, created a value innovation in vacuum cleaners when it launched the Dyson Dual Cyclone in the UK.  This was far easier to use and eliminated vacuum cleaner bags and hence the need to buy replacement bags for the life of the machine.  In so doing, Dyson dramatically increased its vacuum cleaner's suction power against the industry average.  However, given the radically superior value of its product and the fact that its value innovation was patentable, Dyson was strategically in a position to set its price relatively high while still capturing the mass of buyers.  While the vacuum cleaner was priced higher, it was still judged to be a leap in value and within the economic reach of the mass of buyers.  Thus the conventional monopolists' practice of restricting supply through a high price premium is not followed even in these instances. 
 

Dead weight loss
In the production economy, companies with dominant market positions adversely affected society's welfare in two ways. 

• Firstly, in seeking to maximise their profitability, price would be set high creating a dead weight loss for the mass of customers who, though desiring the good, would find it prohibitive due to unnaturally high prices.

• Secondly, the lack of viable competition would encourage companies with monopolistic positions to be slack and not focus on efficiency, thereby consuming society's resources.

This creates a strong incentive not just to bring costs down but to bring them down to the lowest possible level.