This essay is about how great business ideas for defense from interlopers, a topic of interest to those blessed with great businesses as well as those that hope to get a piece of that great business.  This essay is written from the perspective of the defender, though the insights are applicable to those playing either position.

The discussion here is, however, not completely general.  It is written from the perspective of someone who

• is not the lowest cost producer by virtue of having the lowest cost of labor, facilities, etc.  They may be the low-cost producer because of experience and volume.
• has a differentiated product allowing them to charge a price premium
• is in a business where engineering costs are significant
• needs to show a healthy profit.  This is almost always true for a great business (or I wonder about their management) and not true for the attacker, yet.

Good businesses attract competition.  When competition shows up it becomes a challenge for a company to find ways to beat competitors who are willing, at least for a time, to make much lower profits than the existing business’ owners demand.  I have been in a lot of conversations on the topic and they mostly start like this: “It’s not fair!”

First, as your Mother probably told you, life’s not fair.  So get over it.

We also need to point out that this “sin” is committed not just by the other guys.  Almost all companies with an ambition to grow will support products that are not making money because they think some day this will change; and in some cases it is the right move. Your company is probably (hopefully?) doing this somewhere today.  Why? Because someone believes that over the long term, one can in fact create shareholder value in these businesses.

So, fair or not, we need to find ways to compete with people who have a strategic reason to trash the price, or live in a different capitalistic system, or are desperate, or have huge exit costs, or are just poor at business.  One might argue that, eventually, the profit will eventually decay out of the system as everything becomes commoditized, but history has shown that even for the most commodity-like items (bottled water is my favorite example) some businesses can find ways to be highly profitable and, besides, the world, especially in high-tech businesses, is always changing so that there is no steady state.

In almost every market there are several archetypical competitors.  There is the high-end producer who competes through differentiation (that the customer cares about). There is the operational excellence competitor who competes mostly on price.  There is the customer intimacy competitor who competes by getting very very close to their customer.  And there is often a system integrator (total solution) provider who competes by redefining the product to be the whole system.  While these caricatures are useful, especially for the companies cleaving to these strategies because they help with focus, they are oversimplifications.  The operational excellence company still has to be customer focused and the differentiated product provider must still worry about costs.  But it is a useful framework for thinking about the strategy.  As I mentioned, in this essay I will assume that the leader is differentiated.

The first point to make is that it is important to try to compete against the low-end competitor.  No sense letting a Walmart or SouthWest Airlines grow unchecked in your market area or they will give you no end of problems later on.  Many companies have tried the strategy of ignoring a low-end competitor in their market, and many of these stories have ended badly as the incumbent retreats to ever narrower niches.  Steel mini-mills are one of the classic case studies.

For high tech, learning curves and economies-of-scale control much of the dynamics of the business models.  I discussed this in my essay on the experience curve.  This provides one powerful source of competitive advantage.

There are several other time-tested techniques for fighting lower price competitors.  Let’s talk about a few of them.

• Use the installed base.  The most classic case is offering a speed improvement to an existing popular product.  For example, if you offer an upgrade on your existing system for say, twice the speed for 30% higher price, then it is extremely hard for the competitor with a new tool to fight against this, even if they are half the price new tool vs. new tool.  IBM did this for years in their first “big iron” days. To have these speed upgrades available, it is important to choose an initial architecture that has inherent parallelism and ideally depends a lot on computation.  Parallelism gives opportunities for wider paths.  Computation, of course, just gets cheaper every year.  If the competition fails to show up (my favorite strategy), then it may turn out that the upgrade option fails to show up too.
• The installed base is also useful because of the customer’s costs of training, mistake prevention, load balancing, etc., all encourage the customer to buy what they bought last time.  This is, by the way, another one of the reasons one must fight so hard for market share.  Market share is sticky.  Never underestimate the inertia of people.
• Use the other parts of the value equation, especially if you have a world-wide support network.  Seasoned lightly with FUD (fear, uncertainty, and doubt), total infrastructure and brand can often beat smaller competitors.  The human being making the decision to go with a less established competitor is often risking their career and the incumbent should never fail to reinforce this realization.  On the other hand, careers have been made by taking exactly those risks and making them work, so that sword has two edges.
• One of my favorite techniques is to take an existing product and de-feature it.  For instance, one can remove some features or slow the system down.  It is best if this lowers COGS (cost of goods sold), but that is not necessary.  They key is to de-feature the system until it matches the competitor.  Key point: customers generally do not value features unless you can remove them.  In these cases, you will generally suffer on the gross margin.  Here the issue becomes incremental gross margin vs. total gross margin.  In general, it takes few extra resources to build a few more systems.  The gross margin might be lower, but with little extra investment on engineering and marketing, one can win on profit.  In some systems businesses, one can make it up later in Service or with upgrades.  My own experience in semiconductor equipment is that the upgrades almost always eventually happen.  In fact, I have sometimes taken out features that could not be removed.  How does this work?  I “removed” the feature and then, since I am such a nice guy, I consigned the feature back in, telling the customer that I am letting them have the feature for free, but that they would have to buy it in the next two years (at an appropriate discount).  Engineering, test, and characterization cost was zero.  And I eventually captured the upgrade dollars since after a couple of years the customer (now a different person) could not imagine living without it. In the worst case I would have given the feature away as a concession in some future negotiation.  Key for me was (1) get the sale, (2) don’t spawn any more engineering or product characterization or Service documentation work, and (3) drive the competition nuts.

Now I have sometimes heard from folks that they cannot do this because without all of the features and performance, they will lose the sale.  That means, quite simply, that your product is not good enough.  Sorry. One needs to have products that are sufficiently differentiated from the competitors to command a price premium.  My rule of thumb is that one must be at least 30% better, in some meaningful dimension, to capture a commanding market share and reap substantial financial rewards.  Profits are very non-linear.  Differentiation is oxygen.

Should you re-design the product to be fundamentally lower cost or de-feature the product and suffer the gross margin hit?  This is very industry dependant and it is all in the numbers.  Where are your scarce engineering dollars and scarcer talent best spent?  You have to run the numbers—you may be surprised at how high the hurdle is to improving an existing product cost structure vs designing the next generation.  In the semiconductor equipment industry, it is almost always better to design the next generation product.

Though the stated strategy is performance leadership through differentiated products that provide important features and benefits to customers, it is nevertheless critical to be able to compete with companies that, for a variety of reasons, are willing to sell at low prices.  History has shown that higher market share leads to higher profits and the effect is more pronounced at larger market shares.  That is, it is more profitable to move from 70% market share to 80% than it is to move from 50% to 60%.  Also, low-end competitors create a clear and present danger to businesses because history is full of cases where such competitors eventually moved up stream to the high end of the market.  Therefore every business needs to have a strategy for dealing with the low price competitor.  We talked about several strategies, but fundamentally, if you start with a differentiated product strategy, then the key is to invest engineering and marketing to keep that position and add to it a tactic for having lower incremental costs than the competition.  You win if you can do this and not cannibalize the differentiated high-end market.

Go get ‘em!