Chapter 7: Production Advantages Lost Part 2

Part 1: http://wp.me/p1PgpH-ta and the original post on the case study is here: http://wp.me/p1PgpH-r2

Logan James, a huge contributor to this blog, continues his analysis….

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’s 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.

My comments below are repetitive to Logan James but may reinforce concepts pertinent to this case.

Cisco managed to create competitive advantages for itself, which became stronger as its business grew. The advantages of economies of scale never became important for Philips because the CD market was large relevant to the efficient plant size of two million discs per year. Cisco, by contrast, because of the high software content and attendant high fixed costs for its routers, enjoyed economies of scale advantages. It managed this advantage brilliantly.

Cisco prospered by solving a problem that was widely shared. By removing the language barriers between computer systems, Cisco made networking throughout the enterprise a reality. A company that makes life much better for its customers gets handsomely rewarded, provided it can separate itself from competitors offering similar benefits.

Cisco’s market had two elements missing from the CD market–substantial customer captivity and economies of scale. Routers are sophisticated pieces of equipment, a complex fusion of hardware and software. A high level of technological expertise was required to install and maintain the systems, an expertise not widely available except for those customers with large and skilled IT departments. The others relied on Cisco or its competitors (3Com and Wellfeet). As they expanded their own internal networks, they naturally turned first to the vendor whose equipment they already owned, not wanting to incur the risks and costs of developing a relationship with a new supplier. This asymmetry of familiarity was abetted by another feature of routers that made it difficult for customers to switch: the routers themselves were not compatible. Customers were made captive by complexity.

Cisco’s pre-tax return on invested capital during 1990-2000 was 142%!

Cisco moved into the new market of telecommunications service providers. As an entrant into this market, Cisco was without the critical competitive advantages it enjoyed in the enterprise market. It has no captive customers; so far as established customer relationships are concerned, it was the outsider looking in. Without this kind of customer base, Cisco had no economies of scale in distribution or service support. Because Cisco was working on new products for new customers, it had no economies of scale advantages in research and development either.
Part 3: Next Post.

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