The Three Commodity Traps
Commoditization is an "ugly reality" that confronts many companies the world over, likened to "the black plague" that has killed many firms and debilitated many others, and haunts the conscience of those who have thus far been only marginally affected. A quote: "Everything commoditizes over time. The edges and points of difference get worn off by competition. ... It is easy to imitate and hard to innovate."
The author turns to a dictionary to examine the term: commoditization is the process that renders the goods of any firm interchangeable with the goods of any other. It occurs because all companies assume customers want the same thing, and that the only grounds for competition are external to the product itself (price and convenience). Its symptoms are that firms are constantly lowering product quality to keep in line with falling prices and rising input costs.
The impact of commoditization can be seen in a wide range of products: from consumer package goods, to air travel, to automobiles, to insurance. Its ultimate effects can be seen in industries where a single, gigantic firm controls the market (Wal-Mart in retail, Dell in computers, etc.) or where a few major players exist to provide interchangeable goods (Coke and Pepsi).
It is also true that commoditization in one segment of a market can ripple through an industry. The author considers Zara, a Spanish fashion retailer that dumps low-cost knock-off fashions on the market, which draws cost-conscious shoppers away from higher-end goods.
A premium brand caught in the commodity trap sees its competitive position being eroded, such that it caters to the low-end of the market and diminishes the prestige of its brand. Consider the impact to automobile makers such as Mercedes of providing a discounted model: the economy C-class Mercedes has diminished the prestige of the premium S-class, and as the trend continues, Mercedes is in danger of becoming just another Buick or Oldsmobile, shedding the prestige of premium brand and the ability to appeal to customers who desire quality, such that it can no longer command premium pricing.
Commoditization can happen to any firm or any product: consider that the industry giants of today started out as small players, but defeated the established firms. Consider also that there are today many small players challenging the present-day giants, and that there is one in each industry that will topple them.
Harley-Davidson: Commoditization of a Classic
The author refers to the (somewhat hackneyed) case of Harley-Davidson, which rose from being a small player to becoming an American icon, then fell, then recovered.
Founded in 1903, HD came to define the motorcycle industry. But in the 1970s, it faced its first major commoditization when the company was undermined internally by poor quality, poor service, and a lack of innovation as well as external competition from Japanese firms that took advantage of this weakness to provide cheaper and more reliable motorcycles. As a result, HD's market share nearly halved, falling from 39% to 23% in a span of four years (1979-1983).
It was clear that HD had stepped into a commodity trap, and the company was faced with the conflicting goals of increasing quality while lowering prices. The firm floundered, and was bought out in 1981.
The new management turned the company around: it addressed quality issues but refused to lower prices, instead working on its cache as a symbol of the individualistic American spirit. The sense of independence and nationalism felt by the HD owner overcame price: a significant segment of consumers were successfully convinced that to own any other brand, especially a foreign product, would be an embarrassment.
A key to the turn-around was the establishment of the Harley Owners Group (HOG) as a social phenomenon that grew to over a million members worldwide. Participation in this group fostered advocacy of the product and pride of ownership, such that not only did the firm regain sales of motorcycles, but a significant income from branded apparel and accessories.
Consider that in 2002, HD was able to command 38% higher prices than other brands, even when the Japanese models offered 8% to 12% more power. Better still, consider that HD became the dominant brand of large-displacement motorcycles in Jap[an, the home court of its main rivals.
Thus far, it's a story of recovery - but this was not the end of HD's woes. Because it had stimulated an appetite for a very specific product (large-displacement American-made motorcycles), a few challengers arose domestically: Victory and Big Dog, which became boutique brands, providing highly customized products at a 41% price premium over HD. Big Dog specifically produced just 25K cycles per year (as compared to HD's 300K) but had become the world's largest manufacturer of custom motorcycles, and was siphoning off the upper end of HD's customer base.
This put HD in a difficult position: having to compete with the cheaper models from overseas and the more customized models domestically, meaning that changing its strategy to defend against one would make it more vulnerable to the other.
On top of that, HD was facing the problem of generational preferences. To younger riders, HD was "their father's motorcycle" and its demographic supported that perception: the average HD loyalist was a married man in his mid-forties with an income of $84,300 ... and as such HD had lost its emotional ties to youthful rebellion and become the emblem of mid-life crisis.
The author mentions that he made these observations in 2004, but the executives at HD rejected his suggestions, insisting that HD would remain dominant in the market. Because these insiders were using traditional analytics for company valuation, they were completely blindsided. It took two years, during which the stock price faltered and dealers were losing business on both ends and seeking to regain share by discounting, before the same financial reports began to agree with the author's analysis.
The author indicates "I am not saying I am amazingly prescient" - merely that the traditional metrics are all based upon past data: a monthly or quarterly report. The freshest data you have is a month old, and you will not see a trend emerging until several months have passed. The alarm doesn't go off until the house is ablaze. Especially in dynamic and competitive markets, analyses that require two years' worth of data to identify a downturn is woefully inadequate.
Why Differentiation Is Not Enough
The top-end fashion companies have always been subject to the wiles of consumer preference and the treat of commoditization: do something successful, and soon enough, everyone imitates it, and your distinction is lost. The same thing happens in every other industry, though (historically) at a slower pace.
Returning to the HD case study, it is a constant struggle to escape the trap and stand apart from the pack: as soon as it succeeded in distinguishing itself from Japanese rivals by becoming a high-quality producer, domestic competitors copied its strategy and relegated HD to a commodity manufacturer of mid-range products.
The problem is that differentiation is fleeting, and every firm that wishes to avoid competing on price is constantly looking for ways to differentiate their product. They don't get the results they expect, because everyone is looking at the same data to find a unique solution - but coming to the same conclusions. Or when they invest the time and effort to find something truly unique, it's very quickly imitated.
A quote from the Red Queen in Alice in Wonderland: "Here you must run faster and faster to get nowhere at all!"
As such differentiation alone is not the solution to commoditization: it can give your brand a boost, and set it apart, but only temporarily. Firms must leverage differentiating to create a lasting advantage - which means to change their industry's structure in a way that eliminates, mitigates, or makes irrelevant the commodity traps.
The Three Commodity Traps
The author engaged a research team to explore the notion of commoditization. It's generally accepted that markets commoditize over time, but not clear indication of the forces that create it, nor sufficient consideration as to whether these forces can be resisted.
The study looked at more than thirty industries with a diverse array of products offerings: restaurants, retail, wristwatches, media, artificial sweeteners, automobiles, turbines, music players, potato chips, ship builders, etc. with an eye toward common patterns.
The research was geared to answer four fundamental questions:
- What are the common patterns of commoditization?
- Is commoditization a different process for each industry or firm?
- What is the "underlying competitive movement" within an industry that impacts the consideration of costs and revenues?
- What are companies doing to avoid commoditization?
Through this research, the author discovered three very common patterns that affect firms in all industries, each of which has different causes, and each of which requires a different approach:
Deterioration
In this commodity trap, a dominant low-end competitor enters the market (such as Wal-Mart in retail or Zara in fashion) with an aggressive strategy to underprice the market by diminishing quality. They gain the cost-conscious consumer and, over time, erode the value that the quality-conscious consumer places on a given product, such that the market is reduced to the lowest common denominator of quality and price.
Escalation
Escalation is the opposite to deterioration: instead of undercutting one another's prices and diminishing quality, firms are constantly trying to surpass one another's quality and claim a premium price. The best example of this is in consumer electronics, where each firm attempts to provide more features and better performance - a PC manufacturer offers a faster processor to gain advantage, but within a few months its competitors match or surpass its offering.
Proliferation
Proliferation seems to describe a situation that is neither one nor the other: product prices and quality remain largely the same, but the number of manufacturers who offer the same thing at the same price increases, and the competition is based on other factors: which is the most fashionable, which is the most convenient, etc. Fast food is an example: on a given intersection, when one fast food restaurant opens, another one is built across the street in short order, then a few others join, dividing the market in that vicinity between three or four providers whose price and quality is largely the same.
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Any one of these three patterns can lead to the complete commoditization of a product market - and very often, the three are working in concert. Consider the Harley-Davidson case study: HD escaped the deterioration trap by refusing to compromise quality to compete with Japanese firms, then ended up in an escalation trap with other domestic firms, and now faces a proliferation trap as the market for high-end American motorcycles is flooded with competitors.
Commodity Trap Checklist
The author provides a list of questions to consider to assess which trap most endangers a given firm's markets, but it largely breaks down to a few simple factors: your competition and your customers.
Are the most aggressive firms in your industry attempting to capture market by offering lower prices or better products?
How many firms are attempting to capture the same market segment, as defined by price/quality preferences?
Do economies of scale determine pricing in your industry?
Are you struggling to keep your product features up to date with new features that competitors are constantly adding to their products?
Do customers flock to the lowest price or highest quality? Are they seemingly indifferent?
Are customers carved up into a large number of very small niche groups that are each being served by multiple firms?
How heavily do your firms advertise or market their products?
Do you feel that you are in a reactive mode of doing business, responding to what your competitors are doing in terms of price and features rather than innovating?
Do you find that the primary reason that customers were excited to purchase your brand has changed significantly, and continues to shift?
Does the number of firms vying for market share place the customers in a position of power to demand more for less?
(EN: All of this seems to come down to one thing - competition on the basis of price or quality - but the questions do call attention to specific symptoms.)
The Right Strategy to Fit the Trap
Naturally, a company must understand the kind of trap it faces in order to escape or neutralize it: to do what the competition is doing is the cause of commoditization, and to continue doing the same is to fan the flames.
Even at that, a firm must decide whether combatting or supporting commoditization is in its best advantage. In general, the larger the firm, the greater its economies of scale, and the greater its interest in supporting commoditization, because commoditization works to its advantage.
The author presents some details about topics that will be covered in later chapters, but provides a quick overview (EN: I'm skipping for now - some of the details restate what is said above, other details seem unclear for lack of supporting information at this time.)
He indicates that, in discussions with management in the firms he has encountered in his research, he has often found that they are clearly aware that there is something wrong, but it is a general feeling and not a specific knowledge, which leaves them trapped in the dilemma. As such the point of his book is to give them the tools to analyze and the language to describe their situation, along with some suggestions for a practical set of actions that will help them deal with whichever trap they find themselves in.