THE ART OF EMBRACING COMMODITIZATION By Eric Boudier, Anders Porsborg-Smith, and Martin Reeves hina’s economic slowdown has led Understanding Advantage in Cto overcapacity in many sectors and a Commoditizing Markets significant fall in the prices of many com- Eventually, all products become commod- modities. Although many businesses will itized. (See “BCG Classics Revisited: The regard this as a short-term, cyclical chal- Growth-Share Matrix,” BCG Perspectives, lenge—one they can weather through June 2014, and “Adaptability: The New capacity adjustments—it may prove for Competitive Advantage,” BCG article, Au- others to be something entirely different. It gust 2011.) A company’s optimal strategic may mark the onset of commoditization, a response will depend not only on the in- secular and more severe challenge for which dustry’s current state but also on its likely businesses may be wholly unprepared. evolution. In attempting to gauge the latter, a company must try to determine whether Commoditization is not necessarily a death it can establish a sustainable position on sentence. (See “Escaping the Doghouse: the basis of any one of three factors: its Winning in Commoditized Markets,” BCG cost position; whether, and to what extent, Perspectives, April 2015.) But surviving it, there are imperfections in the market that or even benefiting from it, can entail dras- it can exploit; and its ability to redifferenti- tic measures, such as rethinking strategy, ate its product. (See Exhibit 1.) repositioning the company in the indus- try’s value chain, and overhauling its oper- Many businesses will instinctively lean to- ating model. Many businesses facing com- ward redifferentiating their product (if possi- moditization fail to respond with anywhere ble) or creating a cost advantage (if neces- near the required boldness or speed, how- sary), ignoring the opportunity to exploit ever. Indeed, some may not even recognize market imperfections. But there is potential- or acknowledge the challenge, let alone ly significant value to be gained from all succeed at crafting an effective plan to ad- three courses, depending on how the indus- dress it. try evolves. Companies that have built the For more on this topic, go to bcgperspectives.com Exhibit 1 | Advantage in Commoditizing Markets THREE TYPES OF ADVANTAGE... ...AND FOUR GENERIC BUSINESS MODELS Price Demand Supply Differentiation Premium player advantage C Classical Cost Producer Producer- advantage advantage arbitrageur B A Limited advantage Exit Arbitrageur Low market High market Quantity imperfections imperfections A Cost-based advantage Dynamic advantage B Advantage based on exploitation of market imperfections C Advantage based on product redifferentiation Source: BCG analysis. capabilities necessary to exploit market im- price umbrella for the industry. Upstream perfections, for example, can succeed with oil is an industry in which these dynamics relatively modest capital expenditures and a hold. A variety of technical and political moderate level of risk, making this an attrac- challenges result in a very steep cost curve; tive option under the right circumstances. by focusing on the right segments, players can develop a significant cost-based advan- Cost-Based Advantage. Whether a compa- tage for themselves.1 ny can achieve cost-based advantage hinges on the evolution of the cost curve Exploiting Market Imperfections. The and the company’s relative position on it: ability to create a competitive edge by the flatter the curve, the smaller the exploiting market imperfections of course potential for advantage in the sector. The depends on the prevalence and nature of potential for cost-based advantage is those imperfections. Imperfections make it particularly limited if the process used to difficult for companies to understand make the company’s product is itself where demand will meet supply and, commoditizing—that is, if the process is hence, to predict prices. This often leads to becoming available to any competitor and high price volatility. Players able to detect most of the input factors are commod- and react to such imperfections can itized. This situation is exemplified by such generate significant value for themselves companies as IBM (which, in selling its PC through market arbitrage. The window of unit to Lenovo, exited the laptop business) opportunity may be finite, however, and Nokia (a market leader in the first, because market imperfections may disap- pre-2005 generation of mobile phones), pear as the market commoditizes.2 But both of which were unable to develop imperfections can endure if at least one of significant, sustainable cost-based advan- the following conditions is met: tage within their respective industries despite enjoying substantial market share. • Occasional Undersupply. This results in the potential for unmet demand. In contrast, if the product is commoditized Undersupply often occurs in industries but the process used to make it is not, then with high capital spending, where it cost-based advantage is possible, and low- may be too costly for companies to cost producers can potentially enjoy high invest in additional capacity that will margins as high-cost producers create a seldom be used. An example is the | The Art of Embracing Commoditization 2 periodic volatility in the price of hard Product Redifferentiation. The overhaul of drives, demand for which can some- a product’s characteristics and value propo- times exceed production by the indus- sition can be a highly effective way to try’s two leading manufacturers, confront commoditization. Redifferentiation Seagate and Western Digital. is often the default path of players in commoditizing markets. But companies • Double Inelasticity. Here, the supply must be wary of wishful thinking. Successful curve and the demand curve are redifferentiation is possible only if a compa- simultaneously steep, which can lead to ny can create a premium product that pays large fluctuations in prices in response off, meaning the market value of the to small changes in supply or consump- premium exceeds the company’s associated tion. This dynamic explains the high costs. Redifferentiation can be difficult to price volatility in generic medicines, for achieve in the following circumstances: example. • The production process is very mature, • Exogenous Exposures. Here, unpre- and little technological progress is dictable factors drive potentially large expected. changes in demand or supply curves. Examples include the food and airline • Pricing transparency is high, making it industries, where demand curves are possible for customers to readily gauge subject to weather conditions. the value of differences in product quality or delivery. • Logistics Bottlenecks. These can lead to an imperfect flow of goods in time • The industry’s value chain has already and space. Short-term freight rates in a been deconstructed, and there are few given geographic area can vary greatly, discernible synergies to be achieved for example, because they reflect daily through its reconstruction. variations in supply and the limited ability of service providers to adjust • There are diminishing marginal returns capacity quickly to accommodate on incremental increases in marketing demand. spending. • Product Heterogeneity. Even small • There are cost-effective substitutes for differences in product quality and products, giving customers real choice specifications can change supply-and- and flexibility. demand dynamics and prices. These price differentials are not necessarily Many of these challenges are present in the well correlated with the differences in case of mobile phone carriers. Although value that users assign to products, the sector has many of the characteristics creating arbitrage opportunities. associated with a natural oligopoly (such as Examples can be found in the pharma- high fixed costs, network effects, and con- ceutical market, where imperfections in cession dynamics), regulatory measures the pricing of certain molecules can and consumer familiarity have promoted present attractive arbitrage opportuni- commoditization, with predicable results. ties for makers of generic drugs. The value of subscriptions is becoming in- creasingly transparent to customers; cus- • Information Asymmetry. When tomer acquisition costs are rising; and cus- different players use different sources of tomer loyalty is decreasing. This has forced information, they will rely on different incumbents to think about their commod- ways of estimating a product’s fair itization strategies and how to avoid a race value. The same painting, for example, to the bottom. can be valued very differently by buyers and sellers, resulting in significant value For companies that are in premium posi- creation opportunities for art dealers. tions within their respective industries, | The Art of Embracing Commoditization 3 product redifferentiation is typically the de- and complexity of projects. These fault strategy for dealing with commoditiza- companies also invest heavily in tion. While the strategy can work quite well developing superior project manage- for some—Starbucks, for instance—many ment capabilities because they know companies will find it tricky to execute suc- they have only one chance to get a cessfully. Achieving cost-based advantage or given project right.3 advantage through the exploitation of mar- ket imperfections may prove to be more vi- • Scale and Experience. Scale not only able approaches. We devote the rest of this allows for lower unit costs,