Competitive Advantage  131 manufacturers. Or consider the highly competitive European airline indus- try, where most players typically generate returns very close to their cost of capital—and occasionally below it. Nevertheless, Ryanair earns superior re- turns, thanks to its strategy of strictly point-to-point connections between predominantly secondary airports at the lowest cost in the industry. Finally, industry structure and competitive behavior aren’t fixed; they’re subject to shocks from technological innovation, changes in government regu- lation, and competitive entry—any or all of which can affect individual com- panies or an entire industry. We show in this chapter’s final section that the software and pharmaceutical industries, for example, consistently earn high returns. However, the leading companies may not be the same in 20 years, just as many of today’s leaders were not major players or didn’t even exist 20 years ago. Competitive Advantage Competitive advantage derives from some combination of ten sources, de- fined in Exhibit 8.2. Of these, five allow companies to charge a price pre- mium, four contribute to cost and capital efficiency, and one (often referred to as “network economies”) combines price and cost advantages to produce increasing returns to scale. It is important to understand that competitive ad- vantage drawn from these sources is enjoyed not by entire companies but by particular business units and product lines. This is the only level of com- petition at which the concept of competitive advantage affords you any real traction in strategic thinking; even if a company sells soup or dog food ex- clusively, it may still have individual businesses and product lines with very different degrees of competitive advantage and therefore different returns on invested capital. EXHIBIT 8.2  Sources of Competitive Advantage Price premium Cost and capital efficiency Innovative products: Difficult-to-copy or patented products, services, or technologies Innovative business method: Difficult-to-copy business method that contrasts with established industry practice Quality: Customers willing to pay a premium for a real or perceived difference in quality over and above competing products or services Unique resources: Advantage resulting from inherent geological characteristics or unique access to raw material(s) Brand: Customers willing to pay a premium based on brand, even if there is no clear quality difference Economies of scale: Efficient scale or size for the relevant market Customer lock-in: Customers unwilling or unable to replace a product or service they use with a competing product or service Scalable product/process: Ability to add customers and capacity at negligible marginal cost Rational price discipline: Lower bound on prices established by large industry leaders through price signaling or capacity management Increasing returns to scale: Scalable products that offer increasing value to customers with scale 132  Return on Invested Capital On balance, price premiums offer any business the greatest scope for achieving an attractive ROIC, but they are usually more difficult to achieve than cost efficiencies. Also, the businesses or products with the highest returns are often those that weave together more than one advantage. Price Premium Advantages In commodity markets, companies are typically price takers, meaning they must sell at the market price to generate sales, because the products are hard to differentiate. To sell its products at a price premium, a company must find a way to differentiate its products from those of competitors. We distinguish five sources of price premiums: innovative products, quality, brand, customer lock-in, and rational price discipline. Innovative Products  Innovative goods and services yield high returns on capital if they are protected by patents, are difficult to copy, or both. Absent these protections, even an innovative product won’t do much to generate high returns. Pharmaceutical companies earn high returns because they produce inno- vative products that, although often easy to copy, are protected by patents for up to 20 years. The business can charge a price premium during the protected period, after which generics will enter the market and drive the price down. Even after the patent expires, the holder may enjoy some price “stickiness.” An example of an innovative product line that is not patent protected but still difficult to copy was Apple’s series of iPod MP3 players. MP3 players had been on the market for several years before Apple introduced the iPod, and the core technology was the same for all competitors. The iPod was more successful, however, because of its appealing design and ease of use afforded by its user interface and integration with iTunes. Apple followed a similar approach with the iPhone and iPad; once again, the design and user interface were core drivers of the price premium. Although not patent protected, good design can be difficult to copy. Quality  A term used as broadly as quality requires definition. In the context of competitive advantage and ROIC, quality means a real or perceived differ- ence between one product or service and another for which consumers are willing to pay a higher price. In the car business, for example, BMW enjoys a price premium because customers perceive that its cars handle and drive better than comparable automobiles that cost less. The cost of providing the extra quality is less than the price premium. Hence, BMW has often been able to earn higher returns than many other carmakers. Appliance makers such as Weber can price their products at a premium over those of their competitors because customers perceive their reliability and durability to be superior.