Competitive Advantage by Michael Porter, Part 3

I’ve been doing a series on Michael Porter’s Competitive Advantage book and the value chain analysis framework.  Specifically, I’m using Clorox, Procter & Gamble, and Method Products to provide slight more concrete examples of Porter’s generic strategies and how to analyze them.  The value chain is an odd framework in that Porter uses it to conduct at least two different analyses, for cost advantage and differentiation.  The value chain approach to disaggregating what a company does is similar in both, but from there the two analyses diverge.  In this post, I’ll be doing a deep dive into cost analysis.  This type of work is especially important for figuring out whether a competitor has a true cost advantage (one of Porter’s generic strategies) and also for analyzing your company and competitors in general.

In my last post, I held Clorox up as an example of a cost leadership strategy, but I have realized since that I was wrong.  The company is actually pursuing more of a differentiation strategy.  See the Clorox background section below for details.  Nevertheless, let’s use the company as an example for a cost analysis.  Along the way, we’ll also compare them with Procter & Gamble and Method Products to continue to add more depth to our understanding of the overall value chain analysis.

This post is a long one, so my feelings will not be hurt if you choose to skim it.  Think of it as a reference work.

Clorox Background

The Centennial Strategy Clorox has been pursuing since 2007 convinced me that they are not primarily seeking cost leadership.  The strategy (investor presentation) has a handful of legs:

  • Compete with superior capabilities in the odd-sounding areas of Desire, Decide, and Delight
    • Desire – Use marketing communications to drive broader demand for Clorox brands and expand the scenarios in which people use them
      • Targeting ad spending of 9-10% of sales, almost as high as P&G
    • Decide – Work with retailers to formulate store shelf strategy and develop innovative promotion that will drive category growth based on Clorox brands and provide value that private label brands cannot provide
    • Delight – Deliver high-quality, consumer-preferred products that provide unique benefits (e.g., easier to light Kingsford charcoal, stronger Glad ForceFlex bags) to grow market share
  • Clorox sees consumer trends, like health, wellness, and environmental stability, as growth drivers, and the firm is trying to capitalize on that growth with products like:
    • Green Works, a line of cleaners using natural ingredients launched in early 2008 and marketed with the Sierra Club that now has over 40% market share in its category
    • Burt’s Bees, a natural cosmetics and personal care line acquired for $925 million in 2007
    • Brita, the German water filter products that Clorox distributes in the US
  • The company is also focused on operational effectiveness (better organizational structure and accountability) and driving out waste (cost cutting)

Most of that strategy is driven by differentiation and marketing execution rather than cost.  In recent earnings calls, Clorox also mentioned private label growth and price pressure as two of their biggest challenges, especially for brands like Kingsford, Clorox bleach, and Glad.  That comment validates the idea that they are being attacked from below on pricing rather than being in a cost leader position.

Analyzing Cost Advantage

Porter uses ten factors to analyze cost.  Ten!  It’s been a while since I’ve read Competitive Advantage, so when I saw that, I was not happy.  If you apply all ten factors across all functions and look at customer and product segments, you are looking at an enormous amount of work.  I guess that’s the kind of thing that keeps consultants in work.  At one of my previous positions, a leading consumer products company paid $1.5 million just to have its competitors’ SG&A costs analyzed in detail… in one category!   As you can imagine, the focus of this post will be how to plan this analysis to take the least possible amount of work and still deliver some insight.  We’ll definitely be following the 80/20 rule, but as with all such things, it’s important to be clever in how you cut things out.

So let’s walk through the ten cost factors and come up with a plan for a cost analysis specific to Clorox:

1. Scale

This factor refers back to economies of scale, a relatively straightforward concept.  At greater scale, fixed costs like plant maintenance, advertising, and salespeople can be spread over a bigger production volume , reducing cost per unit.  It’s not quite that simple, however.  For manufacturing in particular, there is often a minimum efficient scale (MES) beyond which greater scale doesn’t particularly reduce costs further.  Large operations can also have diseconomies of scale if they get unwieldy.  Finally, you have to be careful at which level you measure scale.  For advertising, global scale matters.  For a sales territory, scale within that territory is most important to making sure the salesperson’s time is used effectively.  And so on – each activity will have a different measure of scale.

For Clorox, production plants are probably already at MES across all competitors given the maturity of the industry, and we can probably ignore those.  Clorox may get some economies of scale in advertising in categories like bleach, so we should take a closer look at SG&A expense ratios.

2. Learning

Learning refers to the fact that products typically get cheaper to manufacture as you learn how to be more efficient.  Research has shown that experience causes costs to go down by 10-30% per unit every time cumulative production doubles, so the second million widgets will cost 20% less on average than the first million.  Since products like bleach and toilet bowl cleaner have been around forever, we can assume that learning effects have played themselves out.  This driver might be more relevant for newer product lines like Green Works (due to the different ingredients and formulations) and Brita filters.

3. Capacity Utilization

Capacity utilization is often confused with economies of scale.  Basically, fixed costs for a plant are allocated across the units made in that plant.  If the plant is running at 90% of capacity, more units are being made, and each one needs to absorb less fixed costs than if the plant were running at 60% capacity.  When companies over-estimate demand, they end up with empty factories and sometimes take huge hits on capacity utilization.  Since most of Clorox’s products are in stable, slow-growth categories, it seems unlikely that they have capacity utilization issues.  I would still plan on double-checking since this factor can make such a big impact.

4. Linkages

The way different activities are coordinated, or linked, can impact costs, both within the firm and working with suppliers and customers.  Clorox’s investor presentations make mention of providing value-added services to retail chains, so linkages with customers would be a fruitful area to explore.  However, it seems unlikely that Wal-Mart, Clorox’s biggest customer, allows much variation in how it deals with suppliers.  Clorox is also very active in working with suppliers to make relationships more efficient (i.e., “supplier relationship management”).  Further research is warranted into relationships with both major customers and suppliers.

5. Interrelationships

Interrelationships are similar to linkages but across business units within a company.  This concept feels a bit dated since multi-divisional conglomerates are no longer as prevalent as they were from the 50’s through the 80’s, back when Avis was owned by a meat packing company and Paramount Pictures was owned by a metal stamping company.  Wow.  Anyway, Clorox doesn’t have any readily apparent business unit interrelationships, so this is another factor to keep in mind but avoid spending much time on.

6. Integration

Integration refers to whether activities are conducted in-house or outsourced.  Neither approach is inherently more cost-efficient than the other, but differences in integration strategy within an industry can have significant cost impacts.

Based on some brief research, here are some facts on Clorox’s in-house versus outsourced activities:

  • IT was outsourced to HP starting in 2006 (P&G also outsources IT to HP, as well as HR to IBM and some communications and networking to BT – quite the acronym soup).
  • Both Clorox and P&G do their own blow-molding for plastic bottles.
  • Clorox shipping is handled by trucking vendors, and some distribution centers may be outsourced as well.
  • Manufacturing of a few smaller product lines like steel wool pads is outsourced, based on a lack of economies of scale in those areas.

There’s nothing here that makes me think Clorox is pursuing a different approach than major competitors like P&G, but it would be worth checking for exceptions.

7. Timing

This factor mostly applies to rapidly-evolving industries, where being a first-mover or a follower can have significant cost (and differentiation) effects.  Companies that follow counter-cyclical strategies, purchasing assets and acquisitions during down periods, can also reap cost benefits.  Clorox acquired Burt’s Bees in 2007 at the height of the market, which might not have been ideal from a strategic point of view.  Otherwise, I think this factor is not very relevant due to the maturity of the industry.

8. Policies

This category is a bit of a catch-all.  It includes things like compensation policies, product configurations, the level of service provided, customer segments targeted, and so on.  It’s a mess, and Porter’s framework starts to get a little jumbled here, to be honest.  For Clorox and its CPG competitors, I would look primarily at compensation (executive compensation information from financial filings and rank-and-file comp from job postings and salary review sites) and SKU complexity.  Between Clorox and Procter & Gamble, many of these areas probably don’t lead to significant cost differences.  Method probably incurs lower costs here due to being a private company, having a smaller set of products, and distributing primarily through Target rather than every corner store in the country.  However, I’m sure those cost savings are more than offset by the costs of growth, premium product packaging and manufacturing, and smaller scale.  Method’s not successful because of the cost base, but rather because it’s focused and differentiated.  We’ll get to that in another post.

9. Location

Location affects labor, transportation, and raw materials costs, among other things.  It’s complex to analyze because these cost components often move in different directions – for example, moving closer to raw materials may increase outbound transportation costs.  I would mainly look at inbound and outbound transportation costs here.

10. Institutional Factors

Finally we come to institutional factors, which encompass externally-driven factors like unionization and regulatory policy.  It would be interesting to find out whether Clorox is more or less unionized than Procter & Gamble.  Additionally, I would look into whether one company or the other tends to get into more trouble with the EPA, and whether environmental regulations are making a significant impact on costs.  For example, Clorox recently decided to stop shipping chlorine to its seven bleach plants due to regulatory concerns, and is now instead shipping high-strength bleach and then diluting it.

Other Cost Analysis Concerns

Phew, that’s a lot of factors, right?  Before we move on to Clorox itself, there are a couple of additional nuances to keep in mind.  First, there are interrelationships among factors – reducing one cost driver often raises another.  Everything functions as a system, which is why a cost leadership strategy can be quite complex.

Second, consider segments – costs can be very different for different product lines or customer segments, so you may need to analyze some of these factors at the segment rather than business unit level.  For example, the Clorox bleach business is very different from Burt’s Bees personal care products.  It’s obvious, but you need to actually incorporate it in your analysis.  Third, cost dynamics – trends over time change the balance between cost drivers.  When oil went from $50 to $150, transportation costs suddenly became much more important, and companies with less efficient location networks were at a disadvantage.  Predicting cost trends ahead of competitors can be a big factor in achieving cost advantages. The classic example is when Southwest Airlines hedged its fuel purchases before oil prices went through the roof, creating an enormous advantage over the other airlines.

Analyzing Clorox

To recap, here’s the initial list of analyses I would want to do if I were doing a real cost analysis on Clorox for a project:

Factor

Analysis

Scale
  • Analyze SG&A scale, especially advertising and channel promotion
  • Production scale likely at MES – not important
Learning
  • Evaluate for new products like Green Works only
Capacity Utilization
  • Secondary priority, but look for signs of any problems
Linkages
  • Explore supplier development program and services for large customers
  • Also look for signs of internal linkages
Interrelationships
  • Low priority
Integration
  • Level of integration/outsourcing appears similar to competitors, but look for exceptions
Timing
  • Low priority
Policies
  • Analyze compensation policies and SKU complexity
Location
  • Assess inbound and outbound transportation costs
Institutional Factors
  • Look into unionization versus competitors and EPA relations

The real value comes from understanding what Clorox can improve and also what competitors do differently.

How would I get the data?  If I were working for Clorox, much of it would be a combination of accounting data and internal analysis.  Note that you can’t necessarily use accounting data in its raw form because it often combines activities with different economics and because it might not be correctly allocated.  Some form of activity-based costing is ideal.

If I were working for a competitor, I would go through the following progression:

  • Use internal data as a benchmark
  • Do secondary research (i.e., online sources, analyst reports, etc.) to start to identify differences in how activities are organized at various companies
  • Work with internal experts to do what-if analyses based on those differences
  • Use primary research to validate and fine-tune the what-if results

High-Level Financial Metrics

Not to go into too much detail, but looking at gross margins and SG&A costs is also a good way to develop hypotheses about cost versus differentiation strategies.  For example, Clorox’s gross margin tends to hover around 43%, while Procter & Gamble’s is significantly higher at 51%.  Likewise, Clorox has lower SG&A expenses, at around 22% versus 30% for P&G.  These contrasts are consistent with Clorox taking more of a cost-driven strategy than P&G, although it seems like they’ve been moving closer to P&G’s approach.  Differentiation naturally implies premium pricing, resulting in higher gross margins, and it also requires greater non-manufacturing activities, including R&D and marketing.  Within a given industry, margins can be an excellent first indication of how company strategies differ, although of course the quality of execution makes a big difference as well.  Of course, Clorox also competes in more price-sensitive categories than P&G (e.g., bleach and trash bags), which also causes margin differences.

The Clorox Takeaway

Clorox illustrates a few interesting points about Porter’s competitive strategy frameworks.  First, they do not necessarily capture growth dynamics well.  One of Clorox’s biggest problems is its concentration in developed markets like the US and Europe because it missed the boat on expanding into high-growth emerging markets and allowed its competitors to build barriers to entry.  This lack of access to growth doesn’t show up explicitly in the competitive strategy framework, although good strategists weave it in.

Second, the core framework works pretty well but requires some interpretation.  Clorox is stuck in the middle in some product categories but differentiated in others, like Greenworks.  This doesn’t mean that the company can’t be profitable at all in categories where it’s stuck in the middle.  Rather, it means that the firm can’t make an “economic profit,” defined as being higher than the cost of capital.  Good execution with a less than optimal strategy can still return your cost of capital in many industries, but over time competitors not stuck in the middle will pull away.  I would expect Clorox to find maintaining profitability in commodity product areas harder and harder over time.

Finally, the competitive strategy framework dovetails with Porter’s industry analysis approach (the Five Forces).  Trash bags are a less attractive segment than some of Clorox’s other businesses, given limited opportunities to differentiate and around 40% private label market share.  Clorox’s steps, like introducing new bag features, help raise the barriers to entry somewhat, but it’s often very hard to change the equilibrium in a market.

Overall, Clorox has a few product lines that are very strong and runs a decent business based on strong execution and hustle.  But the company does not have a strong competitive advantage in much of the business.

Next Up

Looking at Porter’s analysis of differentiation.


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