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Costs, Revenue, and Business-Level Strategy
Author(s): Gareth R. Jones and John E. Butler
Source: The Academy of Management Review, Vol. 13, No. 2 (Apr., 1988), pp. 202-
Published by: Academy of Management
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?Academy of Management Review, 1988, Vol. 13, No. 2, 202-213. Costs, Revenue, and Business-Level Strategy
GARETH R. JONES
Texas A&M University
JOHN E. BUTLER
University of Washington There is an ongoing debate as to whether the strategies of differentia- tion and cost leadership are mutually exclusive or whether they can be achieved simultaneously. Using transaction cost theory, a model of business-level strategy is developed that reconciles these diver- gent perspectives. It is argued that when transaction costs, produc- tion costs, and revenue are considered within the calculus of a single model, the trade-offs a firm faces when choosing a business strategy become clearer. The effect that business-level strategy has on a firm's profitability is a central issue in the man- agement literature. In particular, there is con- siderable debate over the relative advantages of a cost leadership strategy versus a differentia- tion strategy for achieving high profitability (Hall, 1980; Porter, 1980, 1985). This paper first exam- ines the meaning of both cost leadership and differentiation strategies as they emerged indi- rectly from the debate among Porter (1980, 1985), Hall (1980), and Hambrick (1983). It is argued that both Porter's and Hall's frameworks contain some deficiencies: Porter's fails to account for the un- derlying factors that explain the difference be- tween cost leadership and differentiation and Hall's fails to provide a fully developed explana- tion of the relationship between generic busi- ness-level strategies because it glosses over cost dynamics related to the choice of strategy. Sec- ond, this paper presents a new approach by us- ing transaction cost theory. It is argued that this perspective reconciles the insights of Porter and Hall and leads to a more complete explanation of business-level strategy choices. The theory developed here demonstrates that cost leadership and differentiation strategies are not at opposite ends of a continuum. Rather, they are two different dimensions of strategy, and both must be considered when choosing a business- level strategy. As such, it is the form of the rela- tionship between the low cost and differentiation dimensions that provides meaning to a particu- lar competitive strategy. Additionally, this per- spective examines the conditions under which a firm can pursue both a low cost strategy and a differentiation strategy simultaneously. Differentiation Versus Cost Leadership Often, strategy is viewed as the means by which a firm achieves and sustains a competi- tive advantage over other firms in the industry (Porter, 1980, 1985). Porter's trilogy of cost leader- ship, differentiation, and focused strategies "are three potentially successful strategic approaches to outperforming other firms in the industry" (1980, p. 35). According to Porter, there are two basic kinds of competitive advantage available to a 202 This content downloaded from 14.139.156.82 on Tue, 29 Oct 2019 07:00:44 UTC
Because with either strategy attention must be paid to costs, the implication of Porter's (1985) view is that firms are "stuck in the middle" of the cost dimension, yet some are more to the right (i.e., differentiation strategy), and some are more to the left (i.e., cost leadership strategy). However, Porter's (1985) view does not address Hall's argu- ment that the two strategies can be attained simul- taneously, and Hall's analysis does not explain how a firm can simultaneously pursue a low de- livered cost strategy with a high differentiated position without being "stuck in the middle." Although intuitively both Porter's and Hall's positions seem correct, a simple one-dimensional cost analysis cannot explain the conclusions they draw. Clearly, the relationship between cost leadership and differentiation is more complex than the literature suggests. A transaction cost approach can reconcile Porter's analysis with Hall's and Hambrick's position and can demon- strate the nature of the relationship between ge- neric business-level strategies. A Transaction Cost Approach to
Business-Level Strategy
The market and hierarchies perspective to business-level strategy allows generic business- level strategies to be treated as intermediate gov- ernance mechanisms, between the market or hierarchy, for capturing the customer. In other words, in choosing a competitive strategy the firm is searching for a way to structure the trans- action with the customer. Thus, differentiation and cost leadership are viewed as different ways of managing customer-organization transactions in order to create a profitable and sustainable exchange relationship. For example, a success- ful differentiation strategy insulates a business from competitive rivalry and captures customers by creating customer loyalty and lowering cus- tomer sensitivity to price. In this sense, attempt- ing to build long-term customer commitment can be regarded as a more hierarchy-like gover- nance mechanism. On the other hand, cost lead- ership implies that the firm is attempting to cap- ture customers primarily through price, and this is a more market-like governance mechanism. The question becomes: What causes a firm to adopt a particular form of strategy as an interme- diate governance mechanism for managing the transaction? From a transaction cost perspective, the answer is found in analyzing the production and transaction costs associated with the ex- changes between the firm and customers. Speci- fically, transaction cost theory suggests that the criteria for adopting a governance structure is that of efficiency, where efficiency is defined as the attempt to economize on the sum of produc- tion and transaction costs (Jones & Hill, in press; Williamson, 1979). Sources of Production and Transaction Costs
In transaction cost theory it is customary to
define production costs as all the costs associ- ated with the manufacturing process (Alchian &
Demsetz, 1972). Transaction costs, by contrast,
are costs associated with the transfer and ex- change of goods and services across the organi- zational boundary. For example, at the input or supply side, transaction costs are associated with procurement activities; at the output side they are associated with the disposal of products or services to external customers. In this paper, the
focus is on strategy toward customers; analysis
of supplier-firm transactions will receive less at- tention because these are embedded in the price of the inputs and, thus, are part of the receiving firm's production costs. Here, transaction costs are defined as the negotiating, monitoring, and enforcement costs associated with the transfer of goods and ser- vices between the firm and the customer. This includes all costs associated with the disposal of the product that require direct or indirect contact with the customer. First, transaction costs include the actual costs of writing contracts between the firm and customer (Arrow, 1974). Second, trans- action costs include the indirect costs associated with supplying customers with information or knowledge about the firm's products or services. 204 This content downloaded from 14.139.156.82 on Tue, 29 Oct 2019 07:00:44 UTC
These information costs include advertising, promotion, sales, and marketing expenses. They also include the costs to customers for collecting information about the firm's products in order to make an informed choice. To account for the level of transaction costs found in firm-customer exchange, it is helpful to examine the primary sources of these costs: performance ambiguity, opportunism, and asset specificity. Performance Ambiguity. Performance ambi- guity has been defined as the inability of one party to measure or accurately value the perfor- mance of the other party to an exchange (Ouchi, 1980). In the context of organization-customer relationships, the main source of performance ambiguity is the intrinsic nature of the goods or services exchanged during the transaction. In general, goods and services are some combina- tion of search, experience, and credence quali- ties. Nelson (1970) defined search qualities as those that can be ascertained in the search pro- cess prior to purchase, whereas experience qual- ities are those that can be discovered only after the good has been purchased and used. Cre- dence qualities, according to Darby and Karni (1973), cannot be evaluated through normal use. Instead, assessing their value requires additional costly information, and it is expensive to measure their value even after purchase. Performance ambiguity has a major effect on transaction costs because the more complex or intangible the goods and services, the more cus- tomers must rely on experience and credence qualities, and this makes it more difficult to eval- uate the firm's products (Bowen & Jones, 1986).
In this situation, customers will perceive more
nsk in the exchange, and transaction costs will
increase as both the organization and purchaser bear the information costs of evaluating and con- trolling the exchange. The firm is forced to in- crease customer service and advertising activi- ties in order to educate customers about the value of its products. Similarly, customers must incur costs to acquire information about complex goods. It is for this reason that a firm will incur the costs of creating a brand image or reputation for qual- ity products and services; this economizes on the customer's costs.
Opportunism and Asset Specificity. The po-
tential for either the firm or the customer to act opportunistically is a second factor that will in- crease the transaction costs involved in organi- zation-customer exchange. Opportunism is likely when information asymmetry exists. When buy- ing complex goods and services, it is difficult and expensive for customers to evaluate the quality of their purchases, and they may feel there is an in- centive for the supplying organization to cheat them. As a result, the firm must invest in resources to convince customers they are not being exploit- ed, and this process will increase transaction costs. The potential for opportunism also exists if cus- tomers make an asset-specific investment with one firm, entering into a unique relationship. This investment may be either physical or human in nature. For example, the customer may purchase equipment from a single supplier and develop a specialized relationship with the supplier's sales- people. When customers have made a specific investment with a firm, they may become reluc- tant to change because of the high costs of switch- ing (Porter, 1985). Consequently, the risk for cust- omers is that the firm will exploit them. To prevent this perception from developing, which would cause customers not to enter into the specialized relationship in the first place, firms must invest in the resources to convince customers they are dealing with a reputable organization. From a transaction cost perspective, firms not
only must manage the level of production costs
associated with the manufacturing process, but they also must manage the level of transaction costs associated with firm-customer exchange.
To the extent that competitive advantage is asso-
ciated with the ability to exploit market opportun- ities, the control of transactions with customers is one of the crucial factors associated with the choice of business strategy. The issue becomes one of explaining how attempts to control both production and transaction costs affect firms' product/market choices. 205 This content downloaded from 14.139.156.82 on Tue, 29 Oct 2019 07:00:44 UTC
egy by concentrating on servicing a particular market segment. In general, the greater the level of differentia- tion through market segmentation, the higher are transaction costs because the firm incurs the costs of serving many different customer groups. Often the firm must incur asset-specific investments as more resources are devoted to maintaining cus- tomer-specific relations, such as specialized sales teams. Conversely, to the degree that the firm serves the "average customer," transaction costs will be lower because the firm does not incur the costs of customer-specific exchange. Between these extremes is the focused strategy because the firm will experience transaction costs in de- veloping in-depth relationships with customers and must manage the problems associated with asset-specificity. However, these costs will be lower because the firm does not serve differenti- ated customer groups. From the above argument, it follows that when the firm makes more complex product/market choices, the range and variety of its transactions with customers increase and, thus, transaction costs increase. Therefore, what factors will cause the firm to choose a particular "level" or form of differentiation? Because increases in differentia- tion will increase transaction costs, why should the firm engage in an increased variety of trans- actions and offer a differentiated product range aimed at different market segments? Conversely, under what conditions would firms choose to re- duce the range of transactions they engage in and, hence, reduce transaction costs by produc- ing a homogeneous product for the whole mar- ket? These issues are addressed below. Production Costs, Transaction Costs, and Product/Market Choices As argued above, the transaction costs facing the firm are a function of the complexity of its product/market choices. Firms engage in more complex transactions because increasing levels of differentiation should increase the firm's mar- ket share. This, in turn, normally will lead to a reduction in production costs. Also, differentia- tion will increase revenues, if this allows the firm to charge a premium price for its products.
Empirically, increasing differentiation leads to
an increase in market share for several reasons.
First, on the differentiation by product character-
istics rationale, Buzzell and Wiersama (1981a,
1981b) found that higher product quality was as-
sociated with higher market share, which in turn
lowers production costs because of absolute or
experience-based scale economies (Karnani,
1984). This research was supported by Phillips,
Chang, and Buzzell (1983), who found that "qual-
ity was shown to influence ROI indirectly via its
positive effects on market position (share)" (1983,
p. 40). These findings contradict Porter's (1980)
view that differentiation is incompatible with high
market share.
Second, differentiation by product range and
market scope also has an important effect on
market share. As a firm offers differentiated prod- ucts across many market segments, this increases
the potential market and total demand for its
products. Thus, as the product range widens and
new consumers develop tastes for the product,
demand for the firm's product and its market share
will increase, other things being equal. On the
production cost side of the equation, the effect of
this increased market share is operating efficien-
cies for the firm in the form of economies of scale
(Karnani, 1984). However, even though average
production costs normally will fall as the firm
increases its quantity of products, transaction
costs must be borne in order for these production
costs savings to be achieved. Note that this view
differs from the dominant one in the literature,
namely, that economies of scale are principally
associated with cost leadership. Producing a ho-
mogeneous product for the whole market may
lead to economies of scale; however, this also
is true for a differentiation strategy provided
there are economies of scope (Panzar & Willig,
1977, 1981). This argument is depicted in
Figure 1.
In Figure 1, average production costs decline
to point Q2 because of the economies of scale
and scope associated with increased quantity.
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Costs ATC C -~ / ATRC APC Q3 Q1 Q2 Quantity/ Market Share APC Average Production Costs, ATC = Average Total Costs, ATRC - Average Transaction Costs. Figure 1. Transaction costs, production costs, and product/market choices. After this point, production costs increase as economies of scale and scope are exhausted. After an initial decline (point Q3), transaction costs are shown as positively related to market share/quantity because the latter is hypothesized to be a function of the level of differentiation, for reasons discussed earlier. From a purely cost point of view, given the shape of these curves, firms will differentiate their products and mar- kets to the extent that minimizes the sum of pro- duction and transaction costs. Holding strategy constant, this is where average total costs (ATC) are at a minimum (cost position C in Figure 1). This is the overall low cost position for a firm. Point Q1 designates the quantity associated with this minimum cost position. Beyond Q1, addi- tional segmentation/differentiation cannot be justified on a cost basis only. Before reaching this output, additional production cost savings outweigh additional transaction cost expendi- tures associated with increased differentiation. After this output, increasing the range of transac- tions will increase transaction costs at a rate that will raise the sum of production and transaction costs, even though further production efficien- cies may be possible. For this reason, the mini-
mization of costs occurs at Q1, rather than at Q2,
which is associated with the minimum point on the average production cost (APC) curve. Obviously, the firm must trade this position against revenue considerations to achieve a profit maximizing position. The division of total costs into production costs and transaction costs helps explain why firms limit the definition of their business. In general, trans- action costs will increase before production costs (because of diseconomies of scale and scope in production) so that product/market extensions will be curtailed before economies of scale and scope are exhausted. The implication of this approach for product/market choice is that each firm must consider both cost dimensions simultaneously as it manipulates its total cost position. Costs and Business-Level Strategies It is now possible to examine the implications of this analysis for the firm's choice of generic business-level strategy. We have purposely de- 208 This content downloaded from 14.139.156.82 on Tue, 29 Oct 2019 07:00:44 UTC
Three average transaction cost (ATRC) curves are shown in Figure 2. Each is associated with a different strategy, and each reflects a different level of differentiation. The firm's product/market choice will determine whether the firm is posi- tioned on a higher or lower transaction cost curve. The quantity of its output will determine how far the firm moves along the curve. Normally, the highest curve (ATRC1) is associated with a firm that pursues a differentiation strategy. The lowest curve (ARTC2) is appropriate for a low cost strategy. ATRC1 reflects the higher transac- tion costs associated with a differentiation strat- egy. The differentiated firm has higher transac- tion costs than the low cost strategy firm at all quantities, although the difference becomes more dramatic at higher quantities. This accounts for the different quantity decisions made by firms that are reflected in their average total cost curves (ATC1 and ATC2). For the differentiated firm, the transaction cost/production cost trade-off means that aver- age total costs are minimized at point C1, quan-
tity Qi, on curve ATC1. The firm that pursues a
cost leadership strategy will continue down the production cost curve (APC) until its minimum point. Because it has reduced transaction costs through reduced differentiation, it will be able to produce at quantity Q2 and cost C2, the mini- mum point on its average total cost curve (ATC2).
This is a lower minimum cost position than that
of the differentiated firm. The important point, however, is that each strategy has an overall low cost position, although average total costs may differ between strategies. Also, there is a profit maximizing output for each strategy based on the costs and an assumed revenue function. In the present approach, transaction costs are relevant to the degree to which they contribute to total costs and the rate at which they increase with further differentiation. If the transaction cost dynamics are such that the gap between the average transaction cost curves of the differenti- ated and low cost strategy firms is small, it ap- pears that the differentiator has the competitive advantage. However, the larger this gap, the more attractive a cost leadership strategy ap- proach appears. Obviously, when making this selection consideration must be given to the num- ber of competitors currently pursuing either approach. Also, this analysis is industry-specific, and it is likely that transaction cost considera- tions will be different across different industries. For example, the more complex the goods or services produced by the industry, the more im- portant transaction cost dynamics become (be- cause performance ambiguity, etc., are higher). The present analysis also makes the cost dy- namics of simultaneously pursuing a low cost! differentiation decision clear. Insofar as this strat- egy represents a compromise between a pure cost leadership and a differentiated strategy, the firm will strive to produce at a quantity close to Q3 at a cost between C1 and C2. The relevant transaction cost curve for the joint strategy firm will reflect aspects of both the differentiation (ATRC1) and the low cost (ATRC2) firms. It is de- picted in Figure 2 as curve ATRC3, which is the average of curve ATRC1 and curve ATRC2. Thus, for each strategy there is a uniquely shaped transaction cost curve. The minimum point on the joint strategy firm's average total cost curve (ATC3) results in it producing at quantity Q3 and cost position C3. Thus, this model explains how cost leadership and differentiation may be pursued simulta- neously by showing how the firm can achieve a differentiated position at a lower absolute cost than the pure differentiator. The key link on the cost side is that the quantity/cost relationship must yield a cost advantage relative to the differenti- ated firm and a price (revenue) advantage rela- tive to the low cost strategy firm. It is now possible to examine the implications
of this analysis for the set of issues raised at the
beginning of the paper. First, the analysis agrees with Porter's arguments that a differentiator can- not ignore the position of the cost leader, nor vice-versa, and that a cost trade-off is implied between the two strategies. However, the impli- cation of this analysis is that the strategies are not at opposite ends of the same continuum. 210 This content downloaded from 14.139.156.82 on Tue, 29 Oct 2019 07:00:44 UTC
Rather, two cost continuums must be considered, and the trade-off involved is not between differ- entiation and cost leadership per se; it is be- tween the transaction cost and production cost functions associated with different strategy choices. Second, the analysis also supports Hall's and Hambrick's position that the same underlying fac- tors govern the choice between strategies (in this analysis, transaction and production cost func- tions), but it goes beyond their position in ex- plaining why the strategies of cost leadership and differentiation may be simultaneously achiev- able. That is, it depends on the shape of the transaction cost curve facing firms in the industry. However, it also depends on revenue considera- tions, the issue discussed below.
Revenue, Costs, and Business-Level
Strategy The importance of revenues to the analysis is that up to now, it has been assumed that firms will not produce past the minimum point on their average total cost curve. Therefore, the strategy of differentiation in Figure 2 results in a smaller market share than cost leadership. Although this is compatible with Porter's (1980) analysis, it is not complete because firms do not decide what output to produce on the basis of minimum cost alone. Revenue considerations may cause the firm to expand output and seek a market share beyond the minimum cost position. As noted earlier, one main goal in selecting a generic business strategy is to maximize profits by positioning the business appropriately. From a profit point of view, the rationale behind the choice of a cost leadership position is that profits can be increased in two ways. First, economiz- ing on the sum of transaction and production costs to reach the absolute minimum average total cost position (point C2 in Figure 2) will re- sult, if revenues are held constant, in increased profitability. Second, the development of a cost leadership position may allow the firm to charge a price for its products that will allow it to gain a competitive advantage as compared with its competitors. In this sense, profitability increases if the cost leadership position allows the firm to reduce its price to customers, and this increased profitability leads to an increase in market share which raises total revenues and the level of profits. Thus, for either or both of these reasons profits may increase. Obviously, a combination of high price and low cost is very profitable (e.g., Woo & Cool, 1983), but this does not explain how the firm obtains and maintains its competitive advantage. However, the relationship between costs and profits can be viewed in another way. Suppose the firm decides to allocate resources to obtain a meaningfully differentiated position. In this case, it is incurring a higher level of transaction costs (than for the cost leadership position) at each level of output. For example, it may offer a higher level of after-sales service with specialized sales teams serving particular customer groups or a diverse range of products with unique product characteristics. This will result in increased trans- action cost expenditures for every level of output, as in Figure 2. The strategy of differentiation also affects production costs. When the firm produces a wider range of products that have more differ- entiated product characteristics, it is likely that economies of scale and scope will be more diffi- cult to obtain. This will prevent the differentiated firm from moving further down the production cost curve. The justification for this higher cost position is the ability to charge a premium price. Thus, in terms of strategy, the limit to profitabil- ity for a firm that pursues a strategy of differentia- tion also is a function of the degree to which transaction costs are a large proportion of total costs and a function of the increase in transac- tion costs as the firm continues to differentiate. Once revenues are brought into the analysis, the firm that pursues a differentiation strategy may have an equal or greater market share and equal or greater profitability than one that pur- sues a cost leadership strategy. Similar consid- erations exist for the combined low cost/differen- tiation strategy. The implication is that if the av- erage total costs experienced by a firm pursuing this strategy are below those of a firm that pursues 211 This content downloaded from 14.139.156.82 on Tue, 29 Oct 2019 07:00:44 UTC
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