How commoditization works
In the disruption section, we saw how in the early days of an industry, innovators experiment with multiple value propositions, trying to find benefits-price combinations that click with a sizable number of customers that the company could serve profitably.
But as an industry grows and products go mainstream, incumbents usually gravitate towards one of two generic strategies: one group will compete on value (i.e. differentiation) while others will try to compete on price.
This pattern can be seen in many industries, from retail (Walmart and Sears), to computers (Mac and Dell), Beer (Stella or Heineken and Budweiser) and automobiles (Ford or GM and Toyota or Honda), creating two major clusters that over time lead to the commoditization of the very factors they compete on.
On the one hand, companies offering more value usually do so along dimensions that are known to be important for customers, that is, things like whiteness in toothpaste, download speed in internet services, or storage capacity in computers for example.
These incumbents will keep pushing performance along those dimensions as a way to differentiate from competitors, and at some point their products will be delivering more value in those dimensions than most customers really need.
When that happens, we say that that dimensioned has been commoditized.
Commoditization means that the gross of the market is not willing to pay premium prices for more value any longer. They can already get more than they need from any vendor, turning to price as the decisive factor to pick a product.
For example, it would be more difficult today to find customers willing to pay premium prices for more whiteness in toothpaste, faster internet speed or more storage capacity in personal computers than it was 10 years ago, since now even the most basic offers deliver more than most people need. The gross of buyers in those markets now turn to price to select vendors.
Early in an industry, and while products are not yet good enough for the most demanding customers, incumbents can get away with charging higher prices for more value and exclusive dimensions, but as the value delivered by those solutions increases and exceeds what mainstream customers need, customers will be less willing to pay a premium for something that is way better than needed.
Companies competing on low price on the other hand face a different problem.
In the pursuit of being more cost competitive, these incumbents fragment their value chains, outsourcing subsystems to specialized third parties and creating vendor competition at the subsystem level. To compete, subsystem vendors keep pushing the boundaries of costs and performance until their contribution to the costs of the entire system is only marginal.
This has happened to some extent in the personal computer industry where large manufacturers like Dell and Hewlett-Packard outsource their processor chips to specialized companies like Intel and AMD. Because of the scale and specialization that chip makers are able to achieve, computer makers can buy high performance processors from them at a very low cost.
However, computer chips have already become so powerful and so cheap that they don’t produce an important cost advantage that helps computer vendors offer lower prices, and once again the gross of buyers in the personal computer market are turning to price to decide which computer model they buy.
As differentiation and price become less effective at providing a safe place, a solution is to rethink your value proposition and shift your strategy to serve a different set of needs or a different set of customers.
This strategy may take many forms. For example, you could focus on a narrower customer segment with particular needs, like toothpaste for sensitive teeth (a sub-market of the toothpaste market) or ultra-fast internet services for gamers (a demanding subset of internet users), or you could specialize your value chain above the industry standard, for example a construction company that specializes in bridges, malls or theme parks.
But however you decide to compete, whether in your own market or in someone else’s, through a differentiation approach or focused on lower prices, adopting a dynamic mindset when you adjust directions based on changing market positions will help you protect the profitability of your business.
Sun Wu’s Strategy for Executives can now be downloaded for free here.
Christensen, Clayton M; Anthony, Scott D; Roth, Erik A. Seeing What’s Next: Using the Theories of Innovation to Predict Industry Change. Harvard Business Review Press. Kindle Edition.