COMPETITIVE ANALYSIS BLOG
ARE YOU EXPERIENCED?
Jose Tormo (CBS) MBA MS BS
With apologies to Jimi Hendrix, business planners need to understand the experience base of their industry to help predict the price/performance targets for future generations of offerings.
In 1970, the Boston Consulting Group (BCG) published a modest tract called “Perspectives on Experience.” This book showed long term trends in prices for a wide range of commodities, many across 30-50 years or more of history. What the principals of BCG found was an empirical formula that said that the major factor in predicting prices was the cumulative volume of production for that commodity. Industry structure was also a contributing factor, changing the slope of the price graph as competitive intensity and the pace of innovation changed.
Simply stated, firms often compete by developing product and process improvements that deliver lower cost and improved performance, and as long as the industry remains competitive, end users see a nearly steady improvement in perceived value; the rate of improvement is steepest in the early days, when new discoveries are easy to find, and much slower as the industry matures. The price graph is known as the “experience curve.” Mathematically, the ideal fit is a power curve, with the x-axis consisting of cumulative industry production volume in whatever unit means the most to the end purchaser, and the y-axis consisting on inflation-adjusted (constant $) price per unit. On a log-log scale, this power curve would appear as a line, and the slope indicates the rate of experience – the expected price decline for every doubling of cumulative volume.
Here’s how it works: Go back to the start of the market for the product business you seek to model. From Year 1, build a table of shipment volume and observed prices. You should have your own price history, and you can draw on Gartner or other sources for industry and competitive historical pricing for many product categories. Then calculate the cumulative shipment volume and normalize the price to constant dollars.
Armed with this correlation, you can project the value of the offering well into the future; the key variable is the shipment volume for each year you project into the future. There are two key factors to consider when conducting your sensitivity analysis on future conditions:
1. Periods of extraordinary change in demand, typically recession periods (as shown above for 1991);
2. Changes to the fundamental industry structure, such as hypercompetition or the collapse of competition through cartel, or a radical disruptive innovation from another industry.
Demand changes caused by macroeconomic factors usually just show up as slower progress down the same experience curve. On the other hand, a change in the industry structure will change the slope of the overall curve or shift the curve to a completely new, but parallel line.
A similar experience curve may be used to predict unit costs at the firm level: cumulative firm production volume correlates to the firm cost point for the offering. When firms are gaining share, their specific experience base accelerates, resulting in lower costs, and when the firm loses share, it retrenches, trimming the pace of innovation and cost reduction, thereby becoming even less competitive.
The BCG principals identified some key competitive insights from observing market price and volume data across many industry sectors:
1. Competitive share ratios of 2:1 made for a stable experience curve, while closely matched competitors competed far more aggressively and erratically on price. Near monopolists, with relative market shares in excess of 5 (and some showed a relative market share of 10-15 over the nearest competitor) are characterized by very slow price declines over time and volume.
2. Market share is extremely valuable. Competitors with higher and growing share see greater levels of cost reduction compared to their more sedate competitors. This translates directly to higher profitability.
3. When introducing new products to the market, you are best served by launching at an attractive price, winning volume (and experience) quickly. This will lead to lower costs and give you a sustainable advantage over a competitor that seeks to earn the highest possible margin by pricing well above the early high cost point at a sensitive time in the market when volumes are low. The fact that volumes are low means that the economic impact of underpricing is minimal. The game console industry uses this strategy vigorously, selling hardware near or below cost at launch, but earning a rich profit after the third year of shipments.
This author worked with others to leverage the concepts of experience to help predict price points for a variety of proprietary offerings, including semiconductors for specialty applications, cell phones, pagers, modems, PCs, servers, and automobiles. We found that the correlations worked equally well for complex products as for commodities, and during periods of rapid industry growth, we used the curves to help predict price shifts on a quarterly basis for different classes of offerings.
This technique will help predict market and competitive price points well into the future, and should be the basis for future generation product specifications. Too many planners rely simply on recent pricing to predict the requirements for future products, but an examination of the total history of the category will give you additional insight into appropriate targets for 2, 3, or more future generations of the offerings.
ABOUT THE AUTHOR
Jose Tormo (CBS) MBA MS BS is an approved Certified Business Specialist (CBS) with the Academy of Business Strategy and his specialist subject is competitive analysis. He has achieved an MBA from Stanford University and an MS and BS in Chemistry. He has been employed as a CEO, Vice President and Director and has experience within the semiconductor, communications equipment and merger and acquisition consultancy industries. His clients or employers have included Advanced Micro devices, Dell Inc, International Rectifier Corporation, Hewlett Packard and Motorola. He has geographical working experience in the USA. His native language is English. His service skills incorporate critical market analysis, small team facilitation and scenario planning. To contact Jose Tormo, please contact the Academy of Business Strategy by forwarding an email.