SOLUTION: 9 – 7 9 8 – 0 6 2 R E V : F E B R U A R Y 2 5 , 2 0 0 6 ______________________________

9 – 7 9 8 – 0 6 2
R E V : F E B R U A R Y 2 5 , 2 0 0 6

________________________________________________________________________________________________________________

Professors Pankaj Ghemawat and Jan W. Rivkin prepared this note as the basis for class discussion. It is based in part on earlier notes by Pankaj
Ghemawat, Tarun Khanna, and Anita McGahan.

Copyright © 1998 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical,
photocopying, recording, or otherwise—without the permission of Harvard Business School.

P A N K A J G H E M A W A T

J A N W . R I V K I N

Creating Competitive Advantage

Some companies generate far greater profits than others. The pharmaceutical maker Schering-
Plough produced an economic profit of more than $10 billion during the period 1984-2002. That is,
the accounting profit it generated exceeded its cost of equity capital by that amount. Over the same
period, U.S. Steel produced an economic loss of nearly $500 million; its cost of capital exceeded its
accounting profit by a wide margin. Such large differences in economic performance are
commonplace. Understanding their roots is crucial for strategists.

Differences in industry structure shed some light on such differences in performance.1 To a
certain extent, Schering-Plough has generated more economic profit than U.S. Steel because the
pharmaceutical industry is structurally more attractive than the steel industry. Rivalry in the
pharmaceutical market is muted by factors such as patent protection, product differentiation, and
expanding demand; in contrast, rivalry in the steel industry is fierce—fueled by excess capacity,
limited differences across products, and slow growth. Many pharmaceutical users hesitate to switch
among products or brands, while steel customers are usually willing to switch among producers to
get a better price. Many pharmaceuticals are made from commodities with little labor input, while
unions exercise such power in the steel industry that labor costs often account for a quarter of total
revenue. Such contrasts in industry-level competitive forces are one reason that the profit levels of
firms in different industries differ. Figure 1 shows, for each of many industries, the spread between
the industry’s return on equity and its cost of equity (the vertical axis) and the average equity in the
industry (the horizontal axis) for the period 1984-2002. Reflecting differences in industry-level
competitive forces, the pharmaceutical industry has been among the greatest generators of economic
profit, while the steel industry as a whole has produced losses. The typical pharmaceutical maker is
far more profitable than the typical steel producer.2

Schering-Plough, however, is not a “typical pharmaceutical maker,” nor is U.S. Steel a “typical
steel producer.” As Figures 2a and 2b illustrate, industry averages can mask large differences in
economic profit within industries. Schering-Plough was far more effective at producing economic
profits than were many drug makers during the 1984-2002 period, while U.S. Steel performed far
worse than many other steel producers. Indeed, recent research indicates that intra-industry
differences in profitability like those shown in Figures 2a and 2b may be larger than differences
across industries such as those in Figure 1.3 Industry-level effects appear to account for 10-20% of the
variation in business profitability while stable within-industry effects account for 30-45%. (Most of
the remainder can be assigned to effects that fluctuate from year to year.)

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

798-062 Creating Competitive Advantage

2

Figure 1 Economic Profits of U.S. Industry Groups, 1984-2002

Source: Compustat, Value Line, Marakon Associates analysis

Figure 2a Economic Profits in the Pharmaceutical Industry, 1984-2002

Source: Compustat, Value Line, Marakon Associates analysis

Avg. Spread
(1984-2002)

Avg. Equity ($B) (1984-2002)

(20%)

(10%)

0%

10%

20%

30%

40%

0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000

Tele Service
Semiconduct

Air Transport
Textile

Steel

Railroad

Paper & For.

For El/Ent.

For Telecom

Power
Entertain

Toiletry & Cosmetic

Soft Drinks
Pharmaceutical

Med Supplies
Computer Software

Tobacco

Publishing
Financial Services

Bank
Retail Store

Petro-Integergrated

Aerospace/
Defense

Computers & Peripherals
Auto Parts

Building Materials
Insurance Property & Casualty

Auto & Truck

Avg. Spread
(1984-2002)

Avg. Equity ($B) (1984-2002)

(20%)

(10%)

0%

10%

20%

30%

40%

0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000

Tele Service
Semiconduct

Air Transport
Textile

Steel

Railroad

Paper & For.

For El/Ent.

For Telecom

Power
Entertain

Toiletry & Cosmetic

Soft Drinks
Pharmaceutical

Med Supplies
Computer Software

Tobacco

Publishing
Financial Services

Bank
Retail Store

Petro-Integergrated

Aerospace/
Defense

Computers & Peripherals
Auto Parts

Building Materials
Insurance Property & Casualty

Auto & Truck

Avg. Spread
(1984-2002)

Avg. Equity ($B) (1984-2002)

(80%)

(60%)

(40%)

(20%)

0%

20%

40%

0 5 10 15 20 25 30 35 40 45 50

Merck & Co

Schering-Plough
Bristol Myers Squibb

Pfizer Inc Wyeth
Lilly (Eli) & Co

Barr Laboratories Inc
Novartis AG – ADR

King Pharmaceuticals Inc

Albany Molecular Resh Inc

Covance Inc

Mylan Laboratories Watson Pharmaceuticals Inc
Forest Laboratories -Cl A
Pharmaceutical Prod Dev Inc

Novo-Nordisk A/S -ADR
Idec Pharmaceuticals Corp

Perrigo Co
Ivax Corp

Andrx Corp

Medicis Pharmaceut Cp -Cl A
Genzyme Corp

Parexel International Corp
Aventis Sa -ADR Chiron Corp

Protein Design Labs Inc
Sicor Inc

Gilead Sciences Inc
Enzon Pharmaceuticals Inc

Abgenix Inc
Cephalon Inc

Neurocrine Biosciences Inc
Tularik Inc

Medimmune Inc
Medarex Inc

Celgene Corp Nektar Therapeutics

Quintiles Transnational Corp
Icn Pharmaceuticals Inc

Avg. Spread
(1984-2002)

Avg. Equity ($B) (1984-2002)

(80%)

(60%)

(40%)

(20%)

0%

20%

40%

0 5 10 15 20 25 30 35 40 45 50

Merck & Co

Schering-Plough
Bristol Myers Squibb

Pfizer Inc Wyeth
Lilly (Eli) & Co

Barr Laboratories Inc
Novartis AG – ADR

King Pharmaceuticals Inc

Albany Molecular Resh Inc

Covance Inc

Mylan Laboratories Watson Pharmaceuticals Inc
Forest Laboratories -Cl A
Pharmaceutical Prod Dev Inc

Novo-Nordisk A/S -ADR
Idec Pharmaceuticals Corp

Perrigo Co
Ivax Corp

Andrx Corp

Medicis Pharmaceut Cp -Cl A
Genzyme Corp

Parexel International Corp
Aventis Sa -ADR Chiron Corp

Protein Design Labs Inc
Sicor Inc

Gilead Sciences Inc
Enzon Pharmaceuticals Inc

Abgenix Inc
Cephalon Inc

Neurocrine Biosciences Inc
Tularik Inc

Medimmune Inc
Medarex Inc

Celgene Corp Nektar Therapeutics

Quintiles Transnational Corp
Icn Pharmaceuticals Inc

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

Creating Competitive Advantage 798-062

3

Figure 2b Economic Profits in the Steel Industry, 1984-2002

Source: Compustat, Value Line, Marakon Associates analysis

In light of this, strategists need a systematic way to understand and analyze within-industry
differences in performance. Toward that end, this note uses the notion of competitive advantage. A
firm is said to have a competitive advantage over its rivals if it has driven a wide wedge between the
willingness to pay it generates among buyers and the costs it incurs—indeed, a wider wedge than its
competitors have achieved.4 A firm with a competitive advantage is positioned to earn superior
profits within its industry. In examining the logic of how firms create competitive advantage, this
note emphasizes two themes. First, to create an advantage, a firm must configure itself to do
something unique and valuable. The firm must ensure that, were it to disappear, someone in its
network of suppliers, customers, and complementors would miss it and no one could replace it
perfectly.5 The first section of the note uses the concept of “added value” to make this point more
precisely. Second, competitive advantage usually comes from the full range of a firm’s activities—
from production to finance, from marketing to logistics—acting in harmony. The essence of creating
advantage is finding an integrated set of choices that distinguishes a firm from its rivals. The second
section of the note shows how managers can analyze the full range of activities to understand the
sources of competitive advantage.

As a preface to the main discussion, it is important to address a few possible misconceptions.

Creating vs. sustaining competitive advantage. The note separates the challenge of creating
competitive advantage at a point in time from the problem of sustaining advantage over time. In
reality, the two issues are married: the choices that establish a firm’s advantage also influence
whether the advantage can be sustained. For instance, in launching its personal financial software
“Quicken,” Intuit chose to offer customers outstanding post-sale assistance over the telephone.
Customers valued the help from trained operators, and customer service became a tool for creating
competitive advantage. Moreover, customer service helped Intuit sustain its advantage over rivals
such as Microsoft. Competitors found it hard to match Intuit’s service operations and its reputation

Avg. Spread
(1984-2002)

Avg. Equity ($B) (1984-2002)

Worthington Industries
Gibraltar Steel Corp

Nucor Corp

Steel Technologies

Commercial Metals

Quanex Corp

Carpenter Technology

Cleveland-Cliffs Inc

United States Steel Corp

AK Steel Holding Corp

Ampco-Pittsburgh Corp

Dofasco Inc

Ryerson Tull Inc

(14%)

(12%)

(10%)

(8%)

(6%)

(4%)

(2%)

0%

2%

4%

6%

0 1 2 3 4 5 6 7 8

Avg. Spread
(1984-2002)

Avg. Equity ($B) (1984-2002)

Worthington Industries
Gibraltar Steel Corp

Nucor Corp

Steel Technologies

Commercial Metals

Quanex Corp

Carpenter Technology

Cleveland-Cliffs Inc

United States Steel Corp

AK Steel Holding Corp

Ampco-Pittsburgh Corp

Dofasco Inc

Ryerson Tull Inc

(14%)

(12%)

(10%)

(8%)

(6%)

(4%)

(2%)

0%

2%

4%

6%

0 1 2 3 4 5 6 7 8

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

798-062 Creating Competitive Advantage

4

for excellent support. In addition, Intuit used information from its service operations to generate a
stream of ideas for improving its product.6

Despite the connections between creating and sustaining advantage, we find it important to
discuss the two processes separately. Each is so complicated that it would be unwieldy to deal with
both at once.

Links to industry analysis. Within-industry differences in performance are often larger than
differences across industries, but it would be wrong to conclude that industry analysis is
unimportant. Industry analysis is crucial to creating competitive advantage for several reasons.

First, companies that generate competitive advantages typically do so by devising strategies that
neutralize the unattractive features of their industries and exploit the attractive features.

Second, industry conditions appear to have a large influence on whether competitive advantages
are even possible.7 In some industries (e.g., computer leasing), conditions “strait-jacket” firms and
leave them little room to establish a superior wedge between willingness to pay and costs. In other
industries (e.g., prepackaged software), conditions permit the most effective firms to enjoy large
advantages over the least.

Finally, market leaders often face a tension between managing industry structure and pursuing an
advantage within that structure. When deciding whether to build a new aluminum smelter, for
instance, Alcoa must consider the impact of the new capacity on industry supply-demand conditions,
not just its effect on Alcoa’s competitive advantage. This is true not only because Alcoa is a large
player in the business, but also because Alcoa is closely tracked by its rivals.

Analysis and creativity. This note takes an analytical approach to competitive advantage. In
actuality, many of the greatest advantages come not from analysis, but from entrepreneurial insight
and trial-and-error. The cold, hard analysis described here is not intended to deny the importance of
insight and trial-and-error. Rather, it aims to guide entrepreneurial creativity and to set a battery of
tests for new business ideas.

The Logic of Value Creation and Distribution

The first and foremost test in this battery concerns “added value,” a concept developed by Adam
Brandenburger, Barry Nalebuff, and Harborne Stuart.8 To introduce the concept, we use the example
of the portal crane business of Harnischfeger Industries.9 We then link added value to competitive
advantage.

Harnischfeger, based in Milwaukee, Wisconsin, manufactured equipment for industrial
customers. Its material handling equipment division served a range of customers, including forest
products companies such as International Paper. In the late 1970s, Harnischfeger began to offer these
customers a new product: portal cranes. Portal cranes were designed to lift entire tree-length logs off
of railcars and trucks and to hoist them around woodyards. The cranes were a significant
improvement over the giant forklifts that they replaced.

In fact, it was possible to calculate the customer benefits reasonably precisely. Each crane
replaced a fleet of forklifts which cost roughly $1.0 million. A crane was also less expensive to
operate than a forklift fleet; it required less labor, fuel, and maintenance, for instance. Altogether
over its lifespan, each crane generated a net present value of $6.5 million of savings in operating
costs. It cost Harnischfeger only $2.5 million to produce and install each crane. Thus a large gap

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

Creating Competitive Advantage 798-062

5

existed between the customer benefits associated with a crane ($1.0 million + $6.5 million) and
Harnischfeger’s costs ($2.5 million). Despite this gap, Harnischfeger was making little profit on its
sales of portal cranes by the late 1980s. What happened?

Willingness to Pay and Supplier Opportunity Cost

A customer’s willingness to pay for a product or service is the maximum amount of money that a
customer would be willing to part with in order to obtain the product or service. In the
Harnischfeger example, a customer considering the purchase of a portal crane would be willing to
pay as much as $7.5 million for the crane. If it cost more than that, the customer would be better off
buying the forklifts for $1 million and paying the extra operating costs of $6.5 million.

The concept of supplier opportunity cost is precisely symmetrical to willingness to pay. It is the
smallest amount that a supplier will accept for the services and resources required to produce a good
or service. We call this an “opportunity cost” because it is dictated by the best opportunities that the
suppliers have to sell their services and resources elsewhere. In the example, the actual cost that
Harnischfeger incurred to deliver a portal crane was $2.5 million. We don’t know what the lowest
amount the suppliers would have accepted actually was, but we will speculate that it was not far
below $2.5 million, say $2.0 million.

Imagine that Harnischfeger is bargaining with International Paper, one of the largest paper
manufacturers, over the price of a portal crane. For now, suppose that Harnischfeger is the only
company that can provide a portal crane and International Paper is the sole customer. The price that
emerges from the bargaining may fall anywhere between $2.5 million, Harnischfeger’s cost, and $7.5
million, International Paper’s willingness to pay. (See Figure 3.) Our theory says nothing about
where the price will fall within this range. If Harnischfeger is a particularly tough bargainer, then the
price will tend toward $7.5 million. If International Paper is the shrewder negotiator, the price will
edge toward $2.5 million.

Figure 3: Division of Value

Supplier
opportunity

cost Cost Price
Willingness

to pay

$2.0
mm

$2.5
mm

? $7.5
mm

Supplier
share

Harnischfeger share International Paper share

Source: Brandenburger and Stuart, “Value-Based Business Strategy,” 1996

The total value created by a transaction is the difference between the customer’s willingness to pay
and the supplier’s opportunity cost. In the example, a sale of a crane to International Paper creates
value of $5.5 million: an item worth $7.5 million to the customer is created from supplied resources
that had a value of only $2.0 million in their next-best use. The value captured by Harnischfeger is
the difference between the negotiated price and $2.5 million. International Paper captures value
equal to $7.5 million minus the price. And suppliers capture $0.5 million (Figure 3).

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

798-062 Creating Competitive Advantage

6

Added Value

A firm’s added value plays a large role in determining how much value it actually captures. The
added value of a firm is the maximal value created by all participants in a transaction minus the
maximal value that could be created without the firm. In essence, it is the value that would be lost to
the world if the firm disappeared. Consider the situation with Harnischfeger as the sole provider of
cranes and International Paper as the only customer. If Harnischfeger opts out of the transaction, the
entire $5.5 million of value goes un-created. Similarly, if International Paper refuses to participate,
$5.5 million of value is no longer generated. Both Harnischfeger and International Paper have an
added value of $5.5 million.

Now consider what happens in the late 1980s when Kranco, a management-buyout firm headed
by former Harnischfeger executives, enters the market for portal cranes. Assume that Kranco
produces an identical product, with costs of $2.5 million and supplier opportunity costs of $2.0
million, and it generates the very same willingness to pay of $7.5 million. The added value of
Harnischfeger is now $0. If it participates in a deal with International Paper, the total value created is
$5.5 million. If it opts out, Kranco can fill its place, and total value of $5.5 million is still generated.

Under a condition known as unrestricted bargaining, the amount of value a firm can claim cannot
exceed its added value. To see why this is so, assume for a moment that a lucky firm does strike a
deal that allows it to capture more than its added value. Then the value left over for the remaining
participants is less than the value that those others could generate by arranging a deal amongst
themselves. The remaining participants could break off and form a separate pact that improves their
collective lot. Any deal which grants a firm more than its added value is fragile because of such
separate pacts. Once Kranco enters, it is not surprising that Harnischfeger captures little value and is
barely profitable. After all, it has little or no added value. (See the top half of Figure 4.)

Figure 4: Added Value with Harnischfeger and Kranco Providing Cranes

Supplier opportunity cost of
Harnischfeger crane = $2.0 mm

Willingness to pay for
Harnischfeger crane = $7.5 mm

Supplier opportunity cost
of Kranco crane = 2.0 mm

Willingness to pay for
Kranco crane = 7.5 mm

Total value created = $5.5 mm

Total value created = $5.5 mm

������������������
������������������ Harnischfeger

added value =
$0.0 mm

Supplier opportunity cost of
Harnischfeger crane = $3.0 mm

Willingness to pay for
Harnischfeger crane = $9.0 mm

Supplier opportunity cost
of Kranco crane = 2.0 mm

Willingness to pay for
Kranco crane = 7.5 mm

Total value created = $6.0 mm

Total value created = $5.5 mm

������������������
������������������ Harnischfeger

added value =
$0.5 mm

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

Creating Competitive Advantage 798-062

7

Suppose now that Harnischfeger discovers a way to add some new services to its core product.
(See the bottom half of Figure 4.) The services boost the willingness to pay of International Paper to
$9.0 million, but, because the services entail additional labor, they raise supplier opportunity costs to
$3.0 million. The total value created with Harnischfeger participating is now $9.0 million – $3.0
million = $6.0 million. The total value if Harnischfeger opts out and Kranco provides the crane is $7.5
million – $2.0 million = $5.5 million. The new service boosts Harnischfeger’s added value from $0 to
$0.5 million, essentially because it raises willingness to pay by more than it increases supplier
opportunity costs. By widening the gap between willingness to pay and supplier opportunity cost,
Harnischfeger increases the amount of value than it can potentially claim.

The Link to Competitive Advantage

The larger is a firm’s added value, the greater is its potential for profit. The logic laid out so far
suggests that a firm can boost its added value by widening the wedge it achieves between customer
willingness to pay and supplier opportunity cost beyond what rivals attain. We say that a firm with
a wider wedge has a competitive advantage in its industry. A firm with a competitive advantage has
added value and therefore the potential for profit. The notion of added value highlights the fact that
competitive advantage derives fundamentally from scarcity. A firm establishes added value by
making sure that it is unique in some valuable way—that the network of suppliers, customers, and
complementors within which it operates is more productive with it than without it and that it is not
readily replaced.

There are two basic ways a firm can establish an advantage. First, the firm can raise customers’
willingness to pay for its products without incurring a commensurate increase in supplier
opportunity cost. Second, the firm can devise a way to reduce supplier opportunity cost without
sacrificing commensurate willingness to pay. Either establishes the wider wedge that defines
competitive advantage.

Costs vs. supplier opportunity costs. So far, we have tried to treat buyers, with their willingness
to pay, and suppliers, with their opportunity costs, symmetrically. Just as willingness to pay captures
the most that buyers will pay for a product, opportunity cost is the least that suppliers will accept for
the resources used to make a product. The symmetry is useful: it reminds us that competitive
advantage can come from better management of supplier relations, not just from a focus on
downstream customers. Recent efforts to streamline supply chains reflect the importance of driving
down supplier opportunity costs.

In practice, however, managers often examine actual costs, not opportunity costs, because data on
actual costs are concrete and available. In the remainder of this note, we focus on the analysis of
actual costs. We assume, in essence, that supplier opportunity costs and actual costs track one
another closely. A firm’s quest for competitive advantage then becomes a search for ways to widen
the wedge between actual costs and willingness to pay.

Activity Analysis of Cost and Willingness to Pay10

The Tension Between Cost and Willingness to Pay

Widening the wedge is difficult because, often, a firm must incur higher costs in order to deliver a
product or service for which customers are willing to pay more. Almost all customers would be
willing to pay more for a Toyota automobile than for a Hyundai, but the costs of manufacturing a

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

798-062 Creating Competitive Advantage

8

Toyota are significantly higher than the costs of making a Hyundai. Toyota’s higher profit margins
derive from the fact that the difference in willingness to pay is greater than the incremental costs
associated with its product. As noted above, a firm can achieve a competitive advantage by devising
a way to (1) raise willingness to pay a great deal with only slight increases in costs or (2) reap large
cost savings with only slight decreases in customer willingness to pay. We call the first a
differentiation strategy and the second a low-cost strategy (Figure 5).11

�����������
�����������
�����������
�����������
�����������
�����������
�����������
�����������

������������
������������
������������
������������
������������

$

Industry
average

competitor

�����������
�����������
�����������
�����������
�����������
�����������
�����������
�����������
�����������
�����������

�������������
�������������
�������������
�������������
�������������

Successful
differentiated

competitor

…

9 – 7 1 4 – 4 1 9

R E V : A P R I L 8 , 2 0 1 4

________________________________________________________________________________________________________________

HBS Senior Fellow David L. Ager and Michael A. Roberto, Trustee Professor of Management at Bryant University, prepared this c ase. This case
was developed from published sources. Funding for the development of this case was provided by Harvard Business Scho ol, and not by the
company. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary
data, or illustrations of effective or ineffective management.

Copyright © 2013, 2014 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-
7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be
digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

D A V I D L . A G E R

M I C H A E L A . R O B E R T O

Trader Joe’s

In July 2013, Market Force Information released the results of a new study in which over 6,000
Americans ranked their favorite supermarkets in a variety of categories. Trader Joe’s ranked No. 1
overall.1 Consumer Reports ranked Trader Joe’s the second-best supermarket in the country in 2012.2

One year earlier, Fast Company named Trader Joe’s the 11th most innovative firm in the U.S.3

Hundreds of people waited in line for the doors to open on March 22, 2013 at the grand opening
of Trader Joe’s in Columbia, South Carolina. Local police directed traffic, and people hunted for
parking at nearby businesses because they couldn’t find a spot in Trader Joe’s parking lot.4
Customers arrived at 3:00 a.m. on June 29, 2012, to line up for the opening of a new Trader Joe’s in
Lexington, Kentucky.5 That same scene played out at new store openings around the country. Job
seekers flooded the firm with applications when they learned of a new store. Meanwhile, retail
experts marveled that the quirky grocer generated much higher sales per square foot than any of its
rivals.

With all that success, Trader Joe’s had attracted imitators. Tesco, the world’s third-largest retailer,
had launched a chain of small neighborhood markets in the western United States. The British firm
appeared to borrow extensively from the Trader Joe’s concept with its Fresh & Easy stores. In April
2013, Tesco announced that it was withdrawing from the U.S. market, hoping to find a buyer for its
approximately 200 stores. The British retailer recorded a $1.8 billion loss associated with its failure in
the U.S. market.6

Tesco’s troubles did not discourage other retailers from introducing smaller-footprint stores. Wal-
Mart, the world’s largest retailer, had experimented with its Neighborhood Markets concept since
1998. These smaller grocery stores differed from traditional Wal-Mart supercenters in size and
product variety. They were roughly 38,000 square feet in size and only offered grocery and pharmacy
items. The Neighborhood Markets concept had evolved over the years and recently began to show
promising results. In 2011 the firm launched Wal-Mart Express, a 12,000–15,000-square-foot store that
the company described as a “bit of a hybrid between a food, pharmacy and convenience store.” The

first 10 stores turned profitable in one year.7

In May 2013, Wal-Mart announced strong comparable store sales growth at these smaller
locations, and the firm indicated that 40% of new store openings over the next year would come in
the small-format category. In 2013, it planned to open over 100 small-format stores. The head of Wal-
Mart’s U.S. business, Bill Simon, declared at an industry conference, “You’ll see us increasingly

moving into smaller formats. They compete really well against multiple channels.”8 Many other

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

714-419 Trader Joe’s

2

retailers, including Target, Kroger, Giant, Tops, and Publix, had launched smaller-format
experiments as well. Meanwhile, Amazon continued to make a push into the grocery business. In
June 2013, Amazon expanded its online grocery service outside of Seattle for the first time, with an
entry into the Los Angeles market. Experts predicted that Amazon would introduce the service in San
Francisco later in the year and as many as 20 additional cities in 2014.9 As the onslaught of new
competition emerged, Trader Joe’s had to consider how it might adapt to cope with these threats.

Company History

Joe Coulombe grew up in San Diego, California during the Great Depression. After completing his
MBA at Stanford in 1954, Coulombe took a job with Rexall, a North American drugstore chain. While
working there, he launched a convenience store chain called Pronto Markets in 1958. Coulombe
eventually acquired the small chain from Rexall and branched out on his own. He secured financing
from Adohr Milk Farms. However, 7-Eleven acquired Adohr Milk Farms in 1965. The dominant
player in the convenience store industry now owned Coulombe’s source of capital, which he found
untenable. Coulombe shifted his strategy and founded Trader Joe’s in 1967. He explained the origins
of the concept:

Scientific American had a story that of all people qualified to go to college, 60% were going.
I felt this newly educated—not smarter but better-educated—class of people would want
something different, and that was the genesis of Trader Joe’s. All Trader Joe’s were located
near centers of learning. Pasadena, where I opened the first one, was because Pasadena is the
epitome of a well-educated town. I reframed this: Trader Joe’s is for overeducated and
underpaid people, for all the classical musicians, museum curators, journalists—that’s why

we’ve always had good press, frankly!10

Trader Joe’s offered products aimed at the sophisticated consumer interested in finding good
bargains. The store tried to offer products (such as whole-bean coffees, sprouted wheat bread, and
black rice) not typically found at supermarkets. The environmental movement had caught
Coulombe’s eye during those early years, which prompted him to sell many natural and organic
foods. Soon the company began offering private label items. The first private label product, granola,

launched in 1972.11 In the ensuing years, Trader Joe’s offered an extensive line of private label items
with brand names such as Trader Joe’s, Trader Ming’s, Trader Jose, Trader Giotto, and the like.
Interestingly, Coulombe also experimented with a variety of nonfood items, ranging from music
albums to pantyhose. In addition, trying to cater to the educated, sophisticated customer, Coulombe
chose to offer a wide selection of California wines. The wine became a focal point in the ensuing
years, while the albums and pantyhose disappeared from the store’s shelves.

The stores tended to be quite small, less than 10,000 square feet in many cases. Trader Joe’s
stocked far fewer items than a typical supermarket. All of its stores adopted a South Seas theme:
Coulombe remembered, “I read that the 747 [Boeing jumbo jet] would radically reduce the cost of
travel, and I came up with the term ‘Trader’ to evoke the South Seas. The first stores were loaded
with marine artifacts.”12 Coulombe also outfitted the employees with Hawaiian shirts. The store
manager became known as the “Captain” of that location, with a “First Mate” serving as his or her
assistant.

Coulombe believed strongly in paying employees a good wage. He decided that his average full-
time employee should earn the median family income for the state of California—$7,000 per year at
the time the company was founded. He said, “What I keep telling people [is] forget about the

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

Trader Joe’s 714-419

3

merchandise; it’s the quality of the people in the stores.”13 He took great pride in the fact that many
employees loved working there and stayed for years.

The company eschewed traditional supermarket advertising, such as coupon-filled circulars in the
Sunday newspaper or television commercials. Instead, it distributed a customer newsletter, which
came to be known as the “Fearless Flyer.” The newsletter provided information on certain products
and introduced new items. It did not offer sales and promotions, however. Instead, the company
embraced an “everyday low-pricing” philosophy. Coulombe also recorded many short radio ads in
which he would tell behind-the-scenes stories about various products. Early commercials were
broadcast on KFAC, a classical music station based in Los Angeles.14

The Aldi acquisition Coulombe pursued a very deliberate growth strategy: during his 20-
year tenure as CEO, he typically opened roughly one store per year. He did so without ever straying
from the Southern California region. In 1979, German grocer Theo Albrecht, who owned one of
Germany’s most successful grocery chains—Aldi North—became enamored with the Trader Joe’s
concept, and acquired the company. Coulombe agreed to remain as CEO, a position he held until
1988. Albrecht ran a lean low-cost operation with minimal overhead. His discount grocery stores bore
a strong resemblance to the Trader Joe’s business model, minus the South Seas theme and a concerted
focus on cultured, urbane consumers. Aldi North sold mostly private label goods at low prices,
stocked far fewer items than a typical supermarket, and maintained a fairly small footprint. It also
carried a small amount of fresh fruits and vegetables. Theo’s brother, Karl, owned a sister chain, Aldi
Sud, which would eventually open small-footprint discount grocery stores in the United States. As of

July 2013, Aldi Sud operated over 1,000 stores across 31 states.15 Together, the two Aldi chains

operated roughly 10,000 stores around the globe.16 Many experts attributed Wal-Mart’s exit from the
German market in 2006 to its failure to match Aldi’s combination of merchandising prowess and
operational efficiency.

Albrecht gave Coulombe a great deal of autonomy to continue running Trader Joe’s as he wished,
and executives from Germany visited the Trader Joe’s headquarters in California only once per year.
However, Trader Joe’s adopted Albrecht’s obsession with secrecy. Theo and Karl Albrecht
maintained very private lives—so much so that German newspapers had a difficult time finding a
photograph of Theo when he died in 2010.17 Consistent with Albrecht’s philosophy, Trader Joe’s did
not have signs with the company’s name or logo at its headquarters in Monrovia, California. Further,
company executives almost never talked to the media. And the company’s website remained very
simple, with little information about the company’s strategy, leadership team, or financial success.

The site did not even have a timeline of the firm’s history until 2009.18

New leadership Coulombe stepped down as CEO in 1988 and was replaced by fellow
Stanford graduate John Shields. Under the new CEO’s leadership, Trader Joe’s expanded beyond its
Southern California base. The company opened its first locations in Northern California in 1988, and
expanded to Arizona in 1993. The next big move entailed the opening of locations on the East Coast.
Trader Joe’s chose Brookline, Massachusetts—a suburb of Boston—as the site of its first East Coast

store.19 The Boston area, of course, had more universities than virtually any metropolitan area in the
country.20

Trader Joe’s began selling its now-famous private label wines in 2002. The wines—sold under the
brand name Charles Shaw Winery—became a huge hit with customers. They affixed the name “Two
Buck Chuck” to the wine, because it sold for $1.99 per bottle in California ($2.99 on the East Coast).

Soon, Charles Shaw wines had become a classic example of “cheap chic.”21

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

714-419 Trader Joe’s

4

Trader Joe’s expanded to the Midwest in 2000, opening stores in the Chicago area. On St. Patrick’s
Day in 2006, the company opened its first store in Manhattan. Soon thereafter, Trader Joe’s made its
debut in the southeastern part of the United States. The stores remained fairly low-tech during this
time. The company did not even introduce price scanners at the checkout lines until 2001, and it
continues to eschew self-checkout to this day. In 2001 Shields stepped down as CEO; by that time, the
chain had grown to 175 locations. Dan Bane succeeded him as chief executive, and was still the
company’s leader as of 2013. Trader Joe’s remained a privately held company, owned by an Albrecht

family trust since Theo’s death in 2010.22

The Supermarket Industry

Wal-Mart, Kroger, Safeway, and Supervalu were the four largest grocers in the United States.23
(See Exhibit 1 for a list of the top grocers in the country.) Supermarkets traditionally operated on
very thin profit margins, and they faced increasing challenges in 2013. Many traditional supermarket
chains found themselves squeezed between premium players such as Whole Foods at the high end of
the market, and “hard discounters” such as Dollar General and Aldi at the low end.24 (See Exhibit 2
for details on the financial performance of several grocery retailers.)

Whole Foods Market ranked as the nation’s leading retailer of organic and natural foods. The
company operated more than 330 stores in the United States, Canada, and the United Kingdom.
Stores averaged roughly 38,000 square feet. Whole Foods locations typically carried 21,000 stock-
keeping units (SKUs). Two-thirds of its sales consisted of perishable items, including bakery and
prepared foods. That percentage ranked much higher than most supermarkets in the country. In 2012
Whole Foods achieved 8.4% same-store sales growth. Over the past decade, the company had

benefited from robust growth in natural and organic food sales in the United States.25

Meanwhile, Dollar General operated the largest number of small discount stores in the United
States, with over 10,000 locations in 40 states. Dollar General’s stores typically carried approximately
10,000 SKUs (mostly simple necessities such as laundry detergent, paper towels, socks, etc.) and had
7,200 square feet of selling space. The average customer completed a shopping trip in roughly 10
minutes. The company reported same-store sales growth of 4.7% in its 2012 annual report.26

Supermarkets had faced another major challenge in recent years. Their share of grocery sales in
the United States fell to 51% in 2011. Just a decade earlier, supermarkets had accounted for two-thirds
of all grocery sales in the nation. But supermarkets lost ground as large discount retailers (Wal-Mart,
Target), warehouse clubs (Costco, BJ’s, Sam’s Club), and pharmacy chains (CVS, Walgreen’s)
increased their emphasis on grocery sales.27

Wal-Mart had become the largest grocery retailer in the nation. The company operated over 3,000
supercenters throughout the U.S. These supercenters had an average of 185,000 square feet and
carried over 100,000 SKUs. Supercenters sold groceries as well as general merchandise, including
apparel, electronics, home goods, hardware, toys, and more. In 2012 Wal-Mart’s grocery revenues
exceeded $100 billion. Wal-Mart’s highly efficient operations enabled it to take share from traditional
supermarkets by dropping prices significantly.28 While Target did not operate nearly as many
supercenters as Wal-Mart, the company had recently expanded its food section dramatically at stores
throughout the country. By 2013, groceries accounted for nearly 20% of Target’s revenue. Like Wal-
Mart, Target found that grocery sales drove store traffic, leading to increased sales of higher-margin

items such as apparel and electronics.29

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

Trader Joe’s 714-419

5

As a result of these trends, many traditional supermarket chains found themselves shedding
employees in order to become more cost competitive. Several experienced financial distress. The
Great Atlantic and Pacific Tea Company (known as the A&P brand) had filed for bankruptcy
protection in December 2010. Supervalu, which operated chains such as Jewel and Albertson’s,
suspended its dividend in July 2012 and hired Goldman Sachs and Greenhill & Co. to examine

strategic options for the business.30 In January 2013, Supervalu sold five of its grocery chains to
private equity investors, cutting the size of the company roughly in half.

Trader Joe’s in 2013

By 2013, Trader Joe’s had expanded to approximately 400 locations across 37 states and the
District of Columbia. Of the 414 stores currently open or set to open in the coming year, 172 were
located in California (see Exhibit 3 for a list of stores by state). Illinois ranked second, with 20
locations. The top five states accounted for 60% of the company’s stores.31 Experts estimated that

Trader Joe’s generated approximately $10 billion in annual revenue.32 The company did not disclose
financial results, but most analysts believed that it achieved higher returns on investment than most
supermarkets in the nation. Experts noted that while Whole Foods Market had the highest sales per
square foot of any publicly traded grocer in the country, Trader Joe’s doubled the sales per square

foot achieved by Whole Foods (see Exhibit 1 for data on the top chains in the country).33

Store operations Many Trader Joe’s stores could be found in old strip malls in suburban
locations. The typical Trader Joe’s store had less than 15,000 square feet of selling space. Many early
locations maintained footprints of approximately 10,000 square feet. The typical supermarket ranged
in size from 40,000 to 50,000 square feet. As a result, Trader Joe’s did not have the wide aisles that
existed in many supermarkets. Writer Dave Gardetta explained the logic of the quirky, cramped
layout of the stores:

This “chevron” pattern is used in all Trader Joe’s stores, aisles canting left. . . . The offbeat
floor arrangement complements Trader Joe’s unregimented persona: “Hey, we just threw up
some shelves, and there they are.” It’s also a retail trick. Angled passageways reveal a store’s
contents in profile to arriving shoppers. Rows squared with the walls (see: any supermarket)
inadvertently conceal their contents from customers peering into a corridor’s mouth looking
for the toothbrush display.34

Checkout lines could be quite long at Trader Joe’s during busy Saturday mornings, and parking
lots tended to be quite crowded. One Los Angeles area blogger complained about it:

I love Trader Joe’s for their prices, for their Joe-Joe’s, for their simmering sauces. But, all the
mushy love I have for Trader Joe’s is nearly outweighed by how much I hate it for having
absolutely awful parking lots. If you don’t live near one of their new and improved stores—
i.e., the ones at Hollywood and Vine or Olympic and Barrington—then you’re stuck with an
archaic lot that is a one-way traffic jam from hell. This is my list of the 5 Worst Trader Joe’s
Parking Lots in LA.35

Trader Joe’s did not invest a great deal in technology within the stores. The company did not offer
self-checkout lanes, and it did not have flat-screen TVs at the checkout counter. CEO Dan Bane joked
about those televisions at rival retailers, noting that Trader Joe’s customers had the opportunity to

actually talk to employees.36

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

714-419 Trader Joe’s

6

Merchandising Trader Joe’s carried about 4,000 SKUs per location, as compared with as
many as 50,000 units for most grocery stores. Eighty percent or more of the products in a Trader Joe’s
store consisted of private label items. (Typical supermarkets generated less than 20% of their sales
through private label goods.) Because of this, customers could not find many of the major brands at
Trader Joe’s. If customers wanted Cheerios cereal or Coca-Cola beverages, they had to go elsewhere.
Nor did Trader Joe’s offer a wide selection of fresh meat or produce. Instead, it featured an extensive
frozen food collection. It also tended to sell fruit by the piece rather than by the pound. Beth Kowitt
of Fortune visited one of the company’s Manhattan stores and commented, “Make no mistake: A
typical family couldn’t do all its shopping at the store. There’s no baby food, toothpicks, or other

necessities. But for this crowd of urbanites and college kids, Trader Joe’s is nirvana.”37

Trader Joe’s buyers scoured the globe for interesting new products and tried not to follow trends.
Instead, they tried to identify new products that customers had not experienced previously. They also
avoided trade shows, which featured products that every other retailer could see. Because the
company stocked limited varieties of each product, its buyers purchased very large quantities of each
SKU at low prices. This enabled them to purchase goods directly from manufacturers, rather than
working through distributors or wholesalers. Trader Joe’s did not charge suppliers to slot their
products on the retailer’s shelves, unlike many rivals. Moreover, the company paid its suppliers
promptly, rather than trying to stretch out its accounts payable for as many days as possible.38

Trader Joe’s maintained a dynamic product mix that made shopping at the store feel like a
treasure hunt. Merchants strove to introduce 10–15 new products per week. As a result, they had to
eliminate 10–15 products each week. Some changes occurred because special seasonal items were
introduced or discontinued. In other cases, the buyers ruthlessly cut products that did not meet sales
goals. Employees became adept at consoling customers searching for discontinued products.39
Coulombe explained how he pursued a scarcity strategy quite deliberately:

I learned that lesson with vintage wines. There’s only so much 1966 Lafite Rothschild. So
we deliberately pursued a policy of discontinuity, as opposed to, say, Coca-Cola, which is in
infinite supply. For example, we had the only vintage-dated, field-specific canned corn in
existence, and it was the best damned canned corn there was. But there was only so much
produced every year, and when you’re out, you’re out.40

The company required its vendors to maintain complete secrecy about their relationship with the
retailer. Trader Joe’s did not want rivals or customers to know how and where it sourced its private
label goods. Suppliers often wanted complete secrecy as well, because they were providing Trader
Joe’s a much lower-cost version of their branded product, which might be selling at higher prices at
Whole Foods or other retailers. Occasionally reports did surface in the media about Trader Joe’s
vendor relationships, and reporters questioned how unique some Trader Joe’s products really were.
For instance, Fortune reported that Stonyfield Farm supplied Trader Joe’s yogurt on the East Coast,

and Pepsi’s snack division produced the retailer’s line of pita chips. 41

Customers Trader Joe’s claimed that 80% of its customers had attended college. The company
described its target market as “intelligent, educated, inquisitive individuals.”42 It focused on people
who were health conscious, enjoyed travel, and liked trying new things. Tony Hales, a store captain,
described the clientele: “Our favorite customers are out-of-work college professors. Well-read, well-
traveled, appreciates a good value.”43 Industry consultant Kevin Kelley described the target customer
as a “Volvo-driving professor who could be CEO of a Fortune 100 company if he could get over his
capitalist angst.”44 One article about the company described the customers as follows:

For the exclusive use of Y. Song, 2022.

This document is authorized for use only by Yuanpu Song in Strategy Spring 2022 taught by DAVID HALLIDAY, George Washington University from Jan 2022 to Jul 2022.

Trader Joe’s 714-419

7

These are people who wear sunscreen, even over their tattoos; who travel on frequent-flier
miles and with the Lonely Planet guide rather than a Frommer’s. People who play guitar and
pay their taxes. Who roller-blade or bike to work on the days they’re not driving the minivan.
Who dress their kids in tie-dye but have really good car seats. Such folks might have
unfortunate thoughts about their fellow Americans while waiting in the sun for a parking

space, but they would never, ever yell at them out the window.45

Trader Joe’s enjoyed a cult-like following. Many customers launched online efforts to persuade
Trader Joe’s to open a store in their region. They created Facebook fan pages, wrote cookbooks
featuring meals prepared with the firm’s products, and waited in line for hours before a new store
grand opening. Founder Coulombe joked, “My children say that the Albrechts own the business, but
I own the cult.”46 One customer, Cherie Twohy, explained her passion for the company:

I’ve always been a Trader Joe’s groupie. I grew up in Southern California, as did TJ’s. . . . As
I became more interested in food and cooking, I found myself cruising the aisles of different TJ
stores, as they expanded, first in California, and then across the country. When I got ready to
open my own cooking school, Chez Cherie, I decided to see how much interest there might be
in classes focused on cooking with Trader Joe’s products. They’ve been so popular and are a
ton of fun to teach. In 2009 I was contacted by a publisher interested in doing a Trader Joe’s
cookbook. Since I’d been doing the classes for years, it seemed like a natural next step. The first

book came out in November 2009 and so far has sold over 70,000 copies!47

Several years earlier, CEO Dan Bane wrote a letter to employees describing why he felt Trader
Joe’s customers had become so loyal to the company. He explained, “Our people are warm and
friendly. It’s fun and an adventure. They find unexpected products. They experience cheap thrills.
Our people are helpful and knowledgeable. They know that we have tested each product to ensure

quality and satisfaction. They trust us.”48

Marketing Trader Joe’s marketed primarily through its Fearless Flyer as well as occasional
radio ads, and never ran television ads. The company produced the flyer and wrote the radio spots
itself rather than hiring an advertising agency. Employees rather than professional actors starred in
the commercials. In addition, one or more employees in each store served as the resident artists who
produced quirky hand-written signage. Trader Joe’s specifically chose not to employ a public
relations agency. Bane explained, “They are a waste of money. If you give your customers great

products at great prices, why do you need one?”49 Many customers had learned about Trader Joe’s
through word of mouth.

Unlike many grocers, the company did not have a loyalty-card program. Trader Joe’s also did not

offer or accept coupons.50 The Fearless Flyer provided information about various products, but it did
not advertise weekly sales. If customers were not satisfied with a product that they purchased, they
could return it with no questions asked. The firm explained its pricing philosophy in the frequently
asked question section of its website.

[Q:] Do you have weekly specials or sales on your products? [A:] “Sale” is a four-letter
word to us. We have low prices, every day. No coupons, no membership cards, no discounts.
You won’t find any glitzy promotions or couponing wars at …