• Strategy
  • McKinsey & Co.

Best Practice Doesn’t Equal Best Strategy

Benchmarking is an important way to improve operational efficiency, but is not a tool for strategic decision making. When competitors all try to play exactly the same game, declining margins are bound to follow.

D1 and D2, the carriers that entered the business in mid-1992, quickly gained market shares that together exceeded 70 percent of the total wireless industry. The carriers very closely matched each other’s pricing schemes, with per minute and fixed monthly prices never differing by more than 3 percent. Both relied heavily on third-party sales outlets in 1993 and 1994 and used very similar advertising methods, channels, and pitches. Both targeted the small but affluent market of business users by advertising high fixed charges and lower charges per minute.

When a third digital carrier, E-Plus, entered the market in mid-1994, it attempted to differentiate itself with a pricing package directed at relatively low-volume private users, including students, families, and senior citizens. To turn these people into customers, E-Plus offered them a low fixed fee and higher per minute charges. In addition, its charges for calls that both originated and terminated within its network were lower than charges for those that did not. Within three months, all of the other networks had imitated E-Plus’s customer-targeting and pricing strategy, effectively destroying that company’s bold attempt to increase differentiation in the industry. (For a more complete treatment of the German wireless market, see Phillip M. Nattermann, “The German Cellular Market: A Case of Involuntary Competition?” Info, Volume 1, Number 4, August 1999.

An analysis of the impact of such crowding indicates that a 10 percent decline in the wireless industry’s SDI resulted in an 11.2 percent decline in margins. The entry of E-Plus into the market in mid-1994 reduced margins by some 19 percent. Between 1992 and 1998, however, the SDI tumbled 83 percent, pulling margins down 50 percent from their peak. In short, it was the low degree of strategic differentiation engineered by the incumbent operators, not the entry of new companies into the market, that was primarily responsible for the lost earnings, which amounted to more than $780 million in 1998 alone.

As strategic differentiation and margins decline, companies frantically attempt to distinguish themselves from competitors, typically with higher ad spending. In the case of the German telecom operators, between 1992 and year-end 1998 a 10 percent decline in the differentiation index was followed by a 13.5 percent overall increase in average advertising expenditures. The 83 percent decline in the SDI from mid-1992 to the end of 1998 was accompanied by a $21 million average annual increase in ad spending, which by the end of that period was 58 percent higher than it had been at the beginning. All of that excess represents earnings lost to the industry as a result of herding.

Strategic herding has destroyed margins in the US personal-computer industry, too. In a 1998 study by the Federal Reserve Bank of Boston, Joanna Stavins, a senior research economist, examined the degree of strategic differentiation and its effect on the margins of the 13 companies that accounted for 98 percent of the market from 1976 to 1988. During that period, the PC industry’s SDI declined by more than 37 percent as firms clustered around the now dominant IBM-clone PC model. As a result of this decline, margins fell during the same period by 56 percent (Exhibit 3), representing $2.95 billion in destroyed margins by 1988. Stavins also showed that increased clustering eroded “brand” effects, which derive from a company’s innate distinguishing characteristics. Brand effects, including such intangibles as reputation and market image, explain that portion of margins that is not attributable to observable product differences.

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