Questions on Chapter 7: Production Advantages Lost: Compact Discs, Data Switches and Toasters

If it’s a penny for your thoughts and you put in your two cents worth, then someone, somewhere is making a penny.” –Steven Wright

Chapter 7: Philips and Cisco in Competition Demysitified

The questions are on Chapter 7 (pages 137 to 159) from Competition Demystified. Also, read: An Open Letter to Warren Buffett Re: Cisco Systems http://www.capatcolumbia.com/Articles/Reports/Buffett.pdf and Philips Case Study: http://www.scribd.com/doc/81400135/pcd

Question 1: Discuss first mover conditions that Philips might have considered in entering the compact disc and compact disc player markets. Consider: market growth, establishment of standards specs, patents, customer captivity, economies of scale.

Question 2: Why was Cisco able to dominate the router market in the 1980s and 1990s in a way that Philips was not in the compact disc market?

Question 3: Explain the statment, “No matter how complex and unique products seem at the start, in the long run they are all toasters.”

We will follow up by the end of the week.

2 responses to “Questions on Chapter 7: Production Advantages Lost: Compact Discs, Data Switches and Toasters

  1. Question 1: Discuss first mover conditions that Philips might have considered in entering the compact disc and compact disc player markets. Consider: market growth, establishment of standards specs, patents, customer captivity, economies of scale.

    Answer:
    First mover conditions:

    Will Philips be able to have any sustainable/structural competitive advantages in this industry? Will we be able to develop and maintain any structural competitive advantages? If so, which ones? Proprietary technology? Patents/trademarks? Learning/experience? Demand? Economies of scale + Customer captivity? How sustainable will these advantages be? What will we be able to do in the long run that competitors cannot do?

    The market for compact discs could be very large in the future. How large? In several years, perhaps 200 million units will be sold. Will growth in the market be good or bad for Philips? That depends on whether the company will have any structural competitive advantages and how sustainable those advantages are.

    Supply: Philips will have no long-term supply based competitive advantages. There are NO patents protecting the CD technology (since it was developed at MIT in the 1950s). We are to assume that any competitors with available funds will enter the market and replicate the technology if they choose. One potential advantage Philips might have is an experience based advantage from being the first mover. We should try to quantify this.

    Demand: Demand for the new CD technology is dependent on the acceptance of the new format by the 5 major recording studios. In order for the technology to be a success, a few studios will need to adopt the format and cause the others to follow suit. Will the recording studios be captive to one supplier of CD technology? Habit? No. Switching/Search costs? No. The recording studios are essentially purchasing a commodity product and are not captive to one particular manufacturer of CDs. If Philips is the only game in town, the studios will be forced to use them. Since we know that there are no patents protecting the CD technology, entrants will flood the market (if they can) and at best they will compete based on price and “product differentiation.”

    It will cost $25 million and take 18 months to build the first manufacturing line with a capacity of 2 million units. Internal projections show that the costs of equipment and time to manufacture new facilities will decline in the future. Therefore, entrants will have an advantage over the incumbents with older manufacturing facilities. Will higher volume offset the disadvantage of using older technology? In 3 years’ time, it is projected that Philips could be selling 10 million units. Variable cost per CD will be roughly $1.77 vs. $3.00 for an entrant in the 0-5 million unit output range. This is an advantage of $1.23. Using the older equipment, Philips fixed costs per unit at 20% cost of capital and 10 year depreciation will be $2.50 vs. $1.12 for a spread disadvantage of $1.38 per CD. Therefore, higher unit volume will be more than offset by the more efficient and productive new facilities.

    Questions: What are the fixed costs relative to the size of the market? Can Philips focus on a niche? If so, which niche? What is the minimum efficient scale? Will competitors take customers and market share away from our company? Why would a recording studio use our products and not potential entrants?

    Plants can be efficiently operated at a scale of 2 million units. Given that demand is projected to reach 200 million in the next several years, companies will enter the market since customer captivity is very limited. In order to reach minimum variable costs per unit, a competitor would need to reach 50 million units per year. If Philips could enter the market and CREATE customer captivity, it could potentially control a large enough share of the market to make entrance by competitors prohibitive. But we have observed that customer captivity is going to be VERY limited.

    How will the establishment of standards specs impact the industry? If you develop the standard that everyone decides to use AND you have some structural competitive advantage (supply, demand, or EOS+CC) then you can benefit from being the company that manufactures the standard (think MSFT). If competitors can copy the standard and you do not have captive customers or patents, you will be competing on a semi-level playing field (you might have some advantages in terms of know how). Since you are first mover and create a new product, you can benefit in the short-term potentially from learning and experience. Over time, competitors will gain the knowledge and experience (do it themselves or hire your people away) so as to make this advantage dissipate. Question: Apple has created several product categories. In the long-run, how do you assess whether Apple can continue to create new products and that competitors will not catch up?

    Question 2: Why was Cisco able to dominate the router market in the 1980s and 1990s in a way that Philips was not in the compact disc market?

    Answer:

    Cisco’s router and switch products were much more complex than Philips’ compact discs. Cisco’s customers, in the beginning, were businesses, government agencies and universities. These institutions required initial setup of router and switch networks as well as continual service to make sure that the networks were up and functioning properly. If you’re a business that runs a network, imagine what it would be like if your network went down and business essentially stopped? Who would you call? Probably Cisco first. You would also view Cisco as the expert in the router/switch markets and would rely on their advice in regards to servicing the network. If you want to upgrade your network equipment, they’re probably getting the first call. So you have captive customers combined with some economies of scale (maybe in R&D, advertising, manufacturing). Note: Would need to check to see if these advantages show up in the numbers.

    Philips sold compact discs, which are not complex. The company was the first mover, like Cisco, but did not benefit from any competitive advantages. Why would a recording studio be captive to one maker of compact discs unless that company had patents protecting its products for a period of time? The purchaser of the CD does not care which company makes the CD, they just want the music. Note that Philips initially targeted a niche part of the music market but planned to take share away from vinyl records in the future.

    Note that growth can harm companies that benefit from EOS + CC because it is easier for competitors to enter the market, take demand and achieve minimum efficient scale. Two examples where this did not occur are MSFT and CSCO.

    Question 3: Explain the statment, “No matter how complex and unique products seem at the start, in the long run they are all toasters.”

    Answer:

    I don’t agree with this statement. As we have learned, product differentiation, brands, etc. are not sources of structural competitive advantages by themselves. In the long-run, not all products and services should be compared to toasters. What about Coke? Wrigley’s chewing gum? These products are far from complex, but I would consider them unique to each company (perhaps local competitive advantages based on economies of scale in advertising, production and customer captivity through habit formation). The reason companies have been selling almost the same products for very long periods of time are due to structural competitive advantages (supply, demand, or EOS + CC). I would say that MOST products/services are toasters in the long-run, just like most businesses are not franchises in the long-run.

    Thanks.

  2. Wow, great comments Logan!
    I’m late to the party but wanted to write something.

    Question 1: Discuss first mover conditions that Philips might have considered in entering the compact disc and compact disc player markets. Consider: market growth, establishment of standards specs, patents, customer captivity, economies of scale.

    By being the first mover, Philips believed it would have a technology/patent (customer captivity), manufacturing advantage (cost advantage) and economies of scale . It seem that Philips was seduced by the new and growing nature of the market. Philips misunderstood who the customer was for the new CD technology. The customer was large peer competitors, not consumers of the CDs. The difference in who the customer of the product was, affected the customer captivity–habit formation. Philips proprietary technology patents did not allow it to lock the market into its system. In regard to manufacturing, the market was so big for CDs and the machines for manufacture get cheaper each year. The Minimum Efficient Scale (MES) kept shifting down and becoming less steep (if I’m remember the chart correctly).

    Question 2: Why was Cisco able to dominate the router market in the 1980s and 1990s in a way that Philips was not in the compact disc market?

    Cisco’s customers needed its tech experience and expertise. So, there was customer captivity. Cisco was meeting their customer’s needs. Using this customer captivity, Cisco could spread its R&D and acquired R&D–aka economies of scale.

    Question 3: Explain the statment, “No matter how complex and unique products seem at the start, in the long run they are all toasters.”

    Greenwald documents how products with no barriers to entry, in the medium and long-term, become low ROIC businesses. For example (toasters and Cisco), equipment becomes cheaper to manufacture (R&D declines and EOS weakens/disappears) and product becomes easier to use and compatibility improves (customer captivity decreases–customer becomes more knowledgeable over time).

    Thanks

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