Competing on Quality: When Less is More

Virtually every firm touts the quality of its product, and almost every annual report or product brochure sees a bright future because of the “quality” of the company’s offerings. But is it really safe to say that higher quality leads to greater profits? Common sense says it’s not that simple. SMU Cox faculty members Chester Chambers and John Semple have conducted new research that answers this deceptively complex question. They developed a new model that includes quality-based competition, product pricing, and production costs to gain new insights into this age-old problem.  

How It Works
The authors’ model helps predict and explain “the diversity of outcomes seen in practice”—something previous models and the related literature has been unable to do. To address this question, they focused on a very general definition of the term quality.   In this case, quality is the presence or level of some attribute whereby users of the product can agree that more is preferable to less. Some of these attributes may be physical parameters like size, speed, or capacity. Other characteristics may be more “fuzzy” like the sound of an instrument, the feel of a mattress, or the way a service provider makes a customer feel. 

Their model works as follows: There are two competitors in a two-stage game. In the first stage, both players choose quality positions fully expecting to compete with the rival firm after the second stage of pricing decisions. This decision on quality has an important impact on production costs. For example, a high-quality Steinway grand piano is produced with a labor-intensive process using skilled craftsmen and rare woods. Given the added costs, what should the price of the Steinway be? Prices are dictated by quality, variable costs, and what the market will bear (demand). Then there’s the lower-quality competitor. For example, Yamaha makes a fine product but even their spokesmen agree that it’s not a Steinway. Thus, Yamaha has chosen a lower position on the quality spectrum. However, this may not be such a bad move because Yamaha is able to use a more automated production process, less stringent material specifications, and fewer labor hours. A natural equilibrium exists in which Yamaha charges a lower price than its rival. One interesting outcome of this model is that the best price for Yamaha to charge is essentially the production cost of the higher-quality rival. If Yamaha tries to charge more, the other player (Steinway) can lower its price, forcing Yamaha to follow suit. If Yamaha charge less, the company is “leaving money on the table.” In this sense, the lower-quality producer ‘inherits its price’ from the higher-quality firm.

The lower-quality competitor stakes its position by trying to keep a distance (separation) in its variable costs compared to the high-quality competitor. Semple elaborated, “One thing we find is that the high-quality firm is really driven by the quality separation. They want as large a gap as possible. And the low-quality firm will try to chip away at that position, because with low costs, their incentive is to move up the quality spectrum. As they increase their quality but keep the cost separation, they’re becoming increasingly profitable. As long as they have high quality with the cost separation, they gain share. They effectively have the features of high quality with less cost.” In this case, the high-quality firm sees its profits erode as it loses market share.

Know Thy Cost Curve
In the authors’ model, variable cost curves can take on different shapes, something previous models neglected entirely or simplified greatly. With a linear cost curve the only way for the lower-quality product to become more like the higher-quality competitor is to incur nearly the same costs. If this is the case, the higher-quality product has a big advantage and the producer of the higher-quality product makes most of the money. Chambers noted, “One can argue that when an industry is new, the relationship between cost and quality is likely to be linear; higher quality comes at a proportionately higher cost. As that industry matures, the cost curve becomes increasingly convex. Firms use technology to automate certain standardized tasks, and this drives cost down somewhat, creating a different type of cost curve.”

A convex cost curve may be one that rises slowly across the quality spectrum (from low to high) and then becomes quite steep at the very high end of the quality spectrum. High quality is most attractive to the high-quality provider when the cost is linear or “not too convex” but becomes increasingly unattractive as the “curvature” of the cost curve increases. If this happens, the high-end product may hold onto a nice niche for a while, and be profitable, but as the lower-quality (cost) competitor gets better and the high-quality player cannot create more quality separation, “the high-quality player’s days may be numbered,” Semple stated.

Taking the High Road
This certainly does not mean that firms should necessarily avoid the highest-quality position. Firms may wish to be in the high-end space because it is a strategy that fits their skills, culture, and history. However, it does imply that these firms must constantly look for ways to increase some notion of the quality of their offerings, and this is best if it is done in a way that competitors cannot replicate. Consider Harley-Davidson motorcycles. As lower-cost Japanese motorcycles were introduced in America in the 1980s, Harley-
Davidson faced extinction. The company then began the process of distinguishing its product as a custom-made, high-end motorcycle. The company also proceeded to brand its bikes in a way that created mystique surrounding the product and buying experience and thus paved the way for sustained competitive advantage. Chambers explained, “Harley-Davidson changed the definition of quality by making brand image or differentiation part of the product. If you’re the high end, it’s best to improve that aspect of quality and spend on promotion strategy to create separation from the lower-cost competitor.”

The firm located at the high-end of the market is always better off maintaining the highest-quality position and defending it. Chambers stated, “The high-end player should invest according to its competitive position. At one time, Maytag was the high-quality producer of appliances, but it didn’t invest enough to keep the high-quality lead and lost its position to higher-end European firms. Maytag is now the lower-quality producer (good quality at lower price), but not voluntarily.” Whirlpool announced the purchase of Maytag the week of March 27, 2006. Potentially, their combined market share and profitability will be enhanced by being positioned away from the high end as Chambers’ and Semple’s model would predict because that’s where the bulk of the market really is. There are also cases when the high-end firm may wish to lower quality (costs) to gain market share.

Changing Roads
The dynamic between quality and price can be applied to the situation of the United States as a manufacturing cost center compared to China. Over time, China has slowly gained share at the expense of the United States and other manufacturing centers. While China’s quality was considered low some decades ago, they have learned and moved up the quality spectrum—taking global market share along the way.

Semple confirms that a similar principle dominates web site development. In the mid-’90s, purchasing a web site was rather costly in terms of quality; web sites were labor-intensive and required specialized knowledge with few sources of supply. Today, there are high-end specialty firms, medium-sized firms, and outsourcing options. Software is available to create your own web site. As firms have utilized the software (or developed their own), the cost of quality has gone down. The boutique web site firms are becoming more specialized niche players with the bulk of the competition offering most of the same services at a fraction of the cost. Thus, the definition of quality is changing and the cost curve is essentially changing from the linear function of the early days to a more convex form in this maturing marketplace.

Concluding Remarks
“The many stories of price and quality combinations within an industry or market are contained within our model,” said Semple. Significantly, this model allows the variable cost curve to take on different shapes, which previous models had not accomplished. The changing shape of the cost curve reveals the changing nature of competition in today’s dynamic business. This has allowed the authors to capture, describe, and predict what is found in the real-world game of quality and price.

Note: The research paper “Quality-Based Competition, Profitability, and Variable Costs” by Chester Chambers, Panos Kouvelis, and John Semple and is forthcoming in Management Science. 

Summary written by Jennifer Warren.