Summary: We often talk about undertaking an initiative in order to create “competitive advantage”, but what does that really mean? What are things you can, and should be doing? Here we examine, the five sources of durable competitive advantage. E-mail. Tweet.

There have been some pithy posts (for example here, and here written on creating durable, or sustainable, competitive advantage; however, the best I’ve ever seen was buried deep in the footnotes of a deck by Khosla Ventures.

In this deck it outlines five major sources of durable competitive advantage:

  1. “Special Access” to Scarce Supply
  2. High Switching Costs
  3. Fixed Cost Leverage
  4. Real-Time Business Process Advantage
  5. Ownable Network Effect

While the footnotes of the deck don’t go into much more detail, I’ll do my best to provide some explanation, and practical examples, on each of these.

1) Special access to scarce supply

Controlling the source of valuable resources is well understood in the the natural resources industries. For instance the way DeBeers controls supply of diamonds, or the OPEC cartel the supply of oil, or unobtainium in the movie Avatar.

Additionally “supply” can come in many other forms than natural resources, as in the following: human talent, event tickets, awards, money, media, and data — to name a few.

What you can do:
Whatever the example, the strategies used to control access to this supply include:

  1. Creating the supply yourself (technology & data companies)
  2. Forging exclusivity relationships (e.g. AT&T and iPhones)
  3. Stockpiling / systematically limiting access

So once you have the “supply” how do you get people to stick with you — which brings us to our next source of durable competitive advantage…

2) High switching costs

Switching costs are the penalties a customer pays when they change from an existing product, or supplier, brand to another. These penalties (or “negative utility” as economists call it) are often monetary, but can also come in the form of time, effort, or social pressure. This dynamic is especially useful in competitive markets, where there is little differentiation amongst options, and creating incentives for customers to stay with you is essential for survival.

What you can do:
Some examples of how to create these switching costs are as follows (derived from this paper by Paul Klemperer of Oxford University):

  • Need for Compatibility: such as add-ons and extensions seen in razors & blades, cameras, Keurig coffee makers, iPhone apps, and other such “platforms”
  • Transaction Costs: where the incumbents levy penalties for switching, such as bank account closure fees, or the effort of migrating your iTunes library to anything else
  • Learning Curves: anything that creates increased training time when switching from one brand to another — such as switching from a PC to a Mac, or iPhone to Blackberry (not like anyone would ever do that)
  • Quality Uncertainty: where the familiarity with the existing product creates fear, uncertainty, or doubt in the quality of the new brand such as with over the counter medications, or athletic equipment
  • Loyalty Mechanisms: frequent flier miles, coupons, or other “membership” bonuses are used to lock customers in problematically
  • Psychological & Social factors: non-economic factors such as “brand-loyalty”, or being part of an elite group…no kid on the schoolyard wants to have a Zune.

3) Fixed cost leverage

Companies that can create high “operating leverage” are able to reap more profit from each additional sale, so long as they don’t have to increase costs to make those sales (or as economists call is low “marginal cost“). The idea is to have higher setup costs, and little to no additional costs with each transaction, to get “economies of scale“.

This is what fuels the high Price to Earnings ratios for software companies — lots of upfront investment to create the application and little to no cost with each additional user or sale. Besides technology, this dynamic can be seen in other industries where there is are large “property, plant, and equipment” (PP&E) costs and little variable costs such as investing in a large scale tooling, airlines, and others.

What you can do:
The key here is to figure out how to wring out marginal costs by using technology or other types of upfront investment, that will enable you to scale at rapid, highly profitable rates…I think this section may have just made dogmatic “lean startup” disciples’ heads explode.

4) Real-time business process advantage

The ability to capture and act on data in a predictive manner, is what underlies this dynamic. This 2004 New York Times article discusses how Wal-Mart used predictive analytics to increase the supply of strawberry Pop-Tarts in the wake of Hurricane Frances. Another classic example is from this HBR article by Gary Loveman, CEO of Harrah’s Entertainment, on how they use real-time predictions to increase guest loyalty.

What you can do:
The idea of all of these examples, is to create tools and processes to systematically gather information, analyze it, and then act on it in a timely manner. Tools such as Salesforce.com, or analytics packages (such as my own Visible Measures) are practical ways to do this; however, the biggest barrier to overcome in employing these methods are often cultural to create data-driven processes.

5) Ownable network effects

In the Khosla deck, there is an explicit mention of what creates not just a network effect, but an “ownable” network effect, that you can reap the benefits of.

For this they outline seven tests your product has to meet:

  1. Groups who interact
  2. A system that greatly improves interaction
  3. Adoption creates value for users – gets better as others use it, without action by owner
  4. Solved chicken & egg problem – can prime pump, get usage by groups. Many such systems have little value until broadly use
  5. Scale matters, and you can get leading scale
  6. Can own, and deter users from moving to lower cost alternatives
  7. Can tax – i.e. you can charge for it

What you can do:
In this case the seven tests provide an explicit guide whereby you can create direct, positive network effects. So to find the durable advantage from an ownable network effects, the first step,prior to these tests, is to design the system around your product such that there is inherent value in your product for the first users, and increasing value as more users are added. To kick-start this, you’ll need to ensure that there is are “initial adoption” incentives for the early customers, followed by intense focus to acquire those initial customers into the network to a point where you can reach a critical mass where the network value takes over.

One other takeaway

If this alone was not illuminating to you, at the very least this should be a reinforcement to always read the footnotes.

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