Wal-Mart's rocky road ahead

The phrases generic strategy and stuck in the middle are fresh in my mind since I began teaching Competitive Environment and Strategy to 50 MBA students this week. And our first case was Wal-Mart -- the key lesson of which is that strategy is about making choices -- Wal-Mart's has been to pursue a Low Cost Producer strategy.

There are two generic strategies:

• Low Cost Producer. A low cost producer charges less than the industry average price but earns higher margins because the lower price enables it to achieve greater market share from which flow economies of scale in areas such as purchasing and operations -- resulting in lower unit costs; and
• Differentiation. If a firm offers more customer value -- e.g., superior quality, selection, and service -- it can charge a higher than average price for its product -- think Neiman Marcus. Although the differentiator has higher costs to deliver that greater customer value, its prices are so much higher that it can earn superior margins.

A firm that avoids making such strategic choices tries to be all things to all people. such a firm is stuck in the middle. It charges average prices and is unable to achieve the scale needed to lower its costs relative to competitors. The result is mediocre growth and profitability.

The key to Wal-Mart's success is that at its inception it made a strategic choice - to be a Low Cost Producer. For instance, in 1993, Wal-Mart's operating margin was 7.5% compared to 3.9% for the industry. Wal-Mart achieved this by making a significant trade-off -- it charged 2% lower prices than competitors and despite its lower gross margin -- 24.9% vs. 27.2% -- was able to achieve lower operating expense margins -- 18.1% vs. 24.6% -- due to economies of scale and the use of technology.

But this strategy which worked well for Wal-Mart when it was opening stores in rural areas has fallen apart as its moved into more urban areas where it faced greater competition. Wal-Mart's announcement today is designed to accelerate its growth in these urban markets.

By dividing its customer base into six segments and trying to tailor individual stores to the needs of these segments, Wal-Mart will need to increase its costs in order to customize the stores. Regrettably for Wal-Mart shareholders, it is not clear that Wal-Mart will be able to raise its prices to the customers in these segments. Therefore, Wal-Mart is likely to be faced with higher costs but unchanged prices.

Wal-Mart faces another strategic dilemma with its move -- many communities near its 3,400 stores are probably diverse mixes of these six segments. Therefore if a local store tailors itself towards the dominant segment, say, empty nesters, it will alienate customers near those stores who happen to belong to the other five segments. The result could be a decline in revenues at those stores.

This is a recipe for ending up stuck in the middle. Wal-Mart could have higher costs, lower prices, and lower revenues per store. Not a change that sounds appealing to this observer.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, and a Professor of Management at Babson College. He has no financial interest in the securities of Wal-Mart.