Michael Porter presented three generic strategies that a firm can use to overcome the five forces and achieve competitive advantage.2 Each of Porter’s generic strategies has the potential to allow a firm to outperform rivals in their industry. The first, overall cost leadership, is based on creating a low-cost position. Here, a firm must manage the relationships throughout the value chain and lower costs throughout the entire chain. Second, differentiation requires a firm to create products and/or services that are unique and valued. Here, the primary emphasis is on “nonprice” attributes for which customers will gladly pay a premium.3 Third, a focus strategy directs attention (or “focus”) toward narrow product lines, buyer segments, or targeted geographic markets, and they must attain advantages through either differentiation or cost leadership.4
Overall Cost Leadership
The first generic strategy is overall cost leadership. Overall cost leadership requires a tight
set of interrelated tactics that include:
• Aggressive construction of efficient-scale facilities.
• Vigorous pursuit of cost reductions from experience.
• Tight cost and overhead control.
• Avoidance of marginal customer accounts.
• Cost minimization in all activities in the firm’s value chain, such as R&D, service,
sales force, and advertising.
One factor often central to an overall cost leadership strategy is the experience curve,
which refers to how business “learns” to lower costs as it gains experience with production
processes. With experience, unit costs of production decline as output increases in most
industries. The experience curve, developed by the Boston Consulting Group in 1968, is a
way of looking at efficiency gains that come with experience. For a range of products, as
cumulative experience doubles, costs and labor hours needed to produce a unit of product
decline by 10 to 30 percent. There are a number of reasons why we find this effect. Among
the most common factors are workers getting better at what they do, product designs being
simplified as the product matures, and production processes being automated and streamlined. However, experience curve gains will be the foundation for a cost advantage only if
the firm knows the source of the cost reduction and can keep these gains proprietary.
To generate above-average performance, a firm following an overall cost leadership position must attain competitive parity on the basis of differentiation relative to competitors.
• Few management layers to reduce overhead costs.
• Standardized accounting practices to minimize personnel required.
Human Resource Management
• Minimize costs associated with employee turnover through effective policies.
• Effective orientation and training programs to maximize employee productivity.
• Effective use of automated technology to reduce scrappage rates.
• Expertise in process engineering to reduce manufacturing costs.
• Effective policy guidelines to ensure low-cost raw materials (with acceptable quality levels).
• Shared purchasing operations with other business units.
• Effective layout of receiving dock operations.
• Effective use of quality control inspectors to minimize rework.
• Effective utilization of delivery fleets.
Marketing and Sales
• Purchase of media in large blocks.
• Sales-force utilization is maximized by territory management.
• Thorough service repair guidelines to minimize repeat maintenance calls.
• Use of single type of vehicle to minimize repair costs.
Overall Cost Leadership: Improving Competitive Position vis-à-vis the Five Forces An overall low-cost position enables a firm to achieve above-average returns despite strong competition. It protects a firm against rivalry from competitors, because lower costs allow a firm to earn returns even if its competitors eroded their profits through intense rivalry. A low-cost position also protects firms against powerful buyers. Buyers can exert power to drive down prices only to the level of the next most efficient producer. Also, a low-cost position provides more flexibility to cope with demands from powerful suppliers for input cost increases. The factors that lead to a low-cost position also provide a substantial entry barriers position with respect to substitute products introduced by new and existing competitors.
Potential Pitfalls of Overall Cost Leadership Strategies Potential pitfalls of an overall cost leadership strategy include:
• Too much focus on one or a few value-chain activities. Would you consider a person
to be astute if he canceled his newspaper subscription and quit eating out to save
money but then “maxed out” several credit cards, requiring him to pay hundreds
of dollars a month in interest charges? Of course not. Similarly, firms need to
pay attention to all activities in the value chain.17 Too often managers make big
cuts in operating expenses but don’t question year-to-year spending on capital
projects. Or managers may decide to cut selling and marketing expenses but
ignore manufacturing expenses. Managers should explore all value-chain activities,
including relationships among them, as candidates for cost reductions.
• Increase in the cost of the inputs on which the advantage is based. Firms can be
vulnerable to price increases in the factors of production. For example, consider
manufacturing firms based in China that rely on low labor costs. Due to demographic
factors, the supply of workers 16 to 24 years old has peaked and will drop by a third
in the next 12 years, thanks to stringent family-planning policies that have sharply
reduced China’s population growth.18 This is leading to upward pressure on labor costs
in Chinese factories, undercutting the cost advantage of firms producing there.
• A strategy that can be imitated too easily. One of the common pitfalls of a cost
leadership strategy is that a firm’s strategy may consist of value-creating activities
that are easy to imitate.19 Such has been the case with online brokers in recent
years.20 As of early 2015, there were over 200 online brokers listed on allstocks.com,
hardly symbolic of an industry where imitation is extremely difficult. And according
to Henry McVey, financial services analyst at Morgan Stanley, “We think you need
five to ten” online brokers.
• A lack of parity on differentiation. As noted earlier, firms striving to attain cost
leadership advantages must obtain a level of parity on differentiation.21 Firms
providing online degree programs may offer low prices. However, they may not
be successful unless they can offer instruction that is perceived as comparable
to traditional providers. For them, parity can be achieved on differentiation
dimensions such as reputation and quality and through signaling mechanisms such
as accreditation agencies.
• Reduced flexibility. Building up a low-cost advantage often requires significant
investments in plant and equipment, distribution systems, and large, economically
scaled operations. As a result, firms often find that these investments limit their
flexibility, leading to great difficulty responding to changes in the environment. For
example, Coors Brewing developed a highly efficient, large-scale brewery in Golden,
Colorado. Coors was one of the most efficient brewers in the world, but its plant was
designed to mass-produce one or two types of beer. When the craft brewing craze
started to grow, the plant was not well equipped to produce smaller batches of craft
beer, and Coors found it difficult to meet this opportunity. Ultimately, Coors had to
buy its way into this movement by acquiring small craft breweries.
• Obsolescence of the basis of cost advantage. Ultimately, the foundation of a firm’s
cost advantage may become obsolete. In such circumstances, other firms develop
new ways of cutting costs, leaving the old cost leaders at a significant disadvantage.
The older cost leaders are often locked into their way of competing and are unable
to respond to the newer, lower-cost means of competing. This is the position
that discount investment advisors now find themselves. Charles Schwab and TD
Ameritrade challenged traditional brokers with lower cost business models. Now,
they find themselves having to respond to a new class of robo-advisor firms, such
as Betterment, that offer even lower cost investment advice using automated data
analytic-based computer systems.
As the name implies, a differentiation strategy consists of creating differences in the firm’s
product or service offering by creating something that is perceived industrywide as unique
and valued by customers.23 Differentiation can take many forms:
• Prestige or brand image (Hotel Monaco, BMW automobiles).24
• Quality (Apple, Ruth’s Chris steak houses, Michelin tires).
• Technology (Martin guitars, North Face camping equipment).
• Innovation (Medtronic medical equipment, Tesla Motors).
• Features (Cannondale mountain bikes, Ducati motorcycles).
• Customer service (Nordstrom department stores, USAA financial services).
• Dealer network (Lexus automobiles, Caterpillar earthmoving equipment).
Firms may differentiate themselves along several different dimensions at once.25 For example, the Cheesecake Factory, an upscale casual restaurant, differentiates itself by offering highquality food, the widest and deepest menu in its class of restaurants, and premium locations.26
Firms achieve and sustain differentiation advantages and attain above-average performance when their price premiums exceed the extra costs incurred in being unique.27 For
example, the Cheesecake Factory must increase consumer prices to offset the higher cost
of premium real estate and producing such a wide menu. Thus, a differentiator will always
seek out ways of distinguishing itself from similar competitors to justify price premiums
greater than the costs incurred by differentiating.28 Clearly, a differentiator cannot ignore
costs. After all, its premium prices would be eroded by a markedly inferior cost position.
Therefore, it must attain a level of cost parity relative to competitors. Differentiators can
do this by reducing costs in all areas that do not affect differentiation. Porsche, for example, invests heavily in engine design—an area in which its customers demand excellence—
but it is less concerned and spends fewer resources in the design of the instrument panel
or the arrangement of switches on the radio.29 Although a differentiation firm needs to
be mindful of costs, it must also regularly and consistently reinforce the foundations of its
differentiation advantage. In doing so, the firm builds a stronger reputation for differentiation, and this reputation can be an enduring source of advantage in its market.
Differentiation: Improving Competitive Position vis-à-vis the Five Forces Differentiation provides protection against rivalry since brand loyalty lowers customer sensitivity to price and
raises customer switching costs.32 By increasing a firm’s margins, differentiation also avoids
the need for a low-cost position. Higher entry barriers result because of customer loyalty
and the firm’s ability to provide uniqueness in its products or services.33 Differentiation also
provides higher margins that enable a firm to deal with supplier power. And it reduces buyer
power, because buyers lack comparable alternatives and are therefore less price-sensitive.34
Supplier power is also decreased because there is a certain amount of prestige associated
with being the supplier to a producer of highly differentiated products and services. Last,
differentiation enhances customer loyalty, thus reducing the threat from substitutes.35
Our examples illustrate these points. Porsche has enjoyed enhanced power over buyers
because its strong reputation makes buyers more willing to pay a premium price. This lessens rivalry, since buyers become less price-sensitive. The prestige associated with its brand
name also lowers supplier power since margins are high. Suppliers would probably desire to
be associated with prestige brands, thus lessening their incentives to drive up prices. Finally,
the loyalty and “peace of mind” associated with a service provider such as Zappos makes
such firms less vulnerable to rivalry or substitute products and services.
Potential Pitfalls of Differentiation Strategies Potential pitfalls of a differentiation strategy
•Uniqueness that is not valuable. A differentiation strategy must provide unique bundles of products and/or services that customers value highly. It’s not enough just to be “different.” An example is Gibson’s Dobro bass guitar. Gibson came up with a unique idea: Design and build an acoustic bass guitar with sufficient sound volume so that amplification wasn’t necessary. The problem with other acoustic bass guitars was that they did not project enough volume because of the low-frequency bass notes. By adding a resonator plate on the body of the traditional acoustic bass, Gibson increased the sound volume. Gibson believed this product would serve a particular niche market—bluegrass and folk artists who played in small group “jams” with other acoustic musicians. Unfortunately, Gibson soon discovered that its targeted market was content with the existing options: an upright bass amplified with a microphone or an acoustic electric guitar. Thus, Gibson developed a unique product, but it was not perceived as valuable by its potential customers.
• Too much differentiation. Firms may strive for quality or service that is higher than
customers desire.37 Thus, they become vulnerable to competitors that provide an
appropriate level of quality at a lower price. For example, consider the expensive
Mercedes-Benz S-Class, which ranged in price between $93,650 and $138,000
for the 2011 models.38 Consumer Reports described it as “sumptuous,” “quiet and
luxurious,” and a “delight to drive.” The magazine also considered it to be the least
reliable sedan available in the United States. According to David Champion, who
runs the testing program, the problems are electronic. “The engineers have gone
a little wild,” he says. “They’ve put every bell and whistle that they think of, and
sometimes they don’t have the attention to detail to make these systems work.” Some
features include a computer-driven suspension that reduces body roll as the vehicle
whips around a corner; cruise control that automatically slows the car down if it gets
too close to another car; and seats that are adjustable 14 ways and are ventilated by a
system that uses eight fans.
• Too high a price premium. This pitfall is quite similar to too much differentiation.
Customers may desire the product, but they are repelled by the price premium. For
example, Duracell was told by the market that it charged too much for batteries.39
The firm tried to sell consumers on its superior-quality products, but the mass
market wasn’t convinced. Why? The price differential was simply too high. At one
CVS drugstore, a four-pack of Energizer AA batteries was on sale at $2.99 compared
with a Duracell four-pack at $4.59. Duracell’s market share dropped 2 percent in a
recent two-year period, and its profits declined over 30 percent. Clearly, the price/
performance proposition Duracell offered customers was not accepted.
• Differentiation that is easily imitated. As we noted in Chapter 3, resources that are
easily imitated cannot lead to sustainable advantages. Similarly, firms may strive
for, and even attain, a differentiation strategy that is successful for a time. However,
the advantages are eroded through imitation. Consider Cereality’s innovative
differentiation strategy of stores that offer a wide variety of cereals and toppings
for around $4.40 As one would expect, once the idea proved successful, competitors
entered the market because much of the initial risk had already been taken. These
new competitors included stores with the following names: the Cereal Cabinet,
The Cereal Bowl, and Bowls: A Cereal Joint. Says David Roth, one of Cereality’s
founders: “With any good business idea, you’re faced with people who see you’ve
cracked the code and who try to cash in on it.”
• Dilution of brand identification through product-line extensions. Firms may erode their
quality brand image by adding products or services with lower prices and less quality.
Although this can increase short-term revenues, it may be detrimental in the long run.
Consider Gucci.41 In the 1980s Gucci wanted to capitalize on its prestigious brand
name by launching an aggressive strategy of revenue growth. It added a set of lowerpriced canvas goods to its product line. It also pushed goods heavily into department
stores and duty-free channels and allowed its name to appear on a host of licensed
items such as watches, eyeglasses, and perfumes. In the short term, this strategy
worked. Sales soared. However, the strategy carried a high price. Gucci’s indiscriminate
approach to expanding its products and channels tarnished its sterling brand. Sales of
its high-end goods (with higher profit margins) fell, causing profits to decline.
• Perceptions of differentiation that vary between buyers and sellers. The issue here is that “beauty is in the eye of the beholder.” Companies must realize that although they may perceive their products and services as differentiated, their customers may view them as commodities. Indeed, in today’s marketplace, many products and services have been reduced to commodities.42 Thus, a firm could overprice its offerings and lose margins altogether if it has to lower prices to reflect market realities.
A focus strategy is based on the choice of a narrow competitive scope within an industry. A firm following this strategy selects a segment or group of segments and tailors its strategy to serve them. The essence of focus is the exploitation of a particular market niche. As you might expect, narrow focus itself (like merely “being different” as a differentiator) is simply not sufficient for above-average performance. The focus strategy, as indicated in Exhibit 5.1, has two variants. In a cost focus, a firm strives to create a cost advantage in its target segment. In a differentiation focus, a firm seeks to differentiate in its target market. Both variants of the focus strategy rely on providing better service than broad-based competitors that are trying to serve the focuser’s target segment. Cost focus exploits differences in cost behavior in some segments, while differentiation focus exploits the special needs of buyers in other segments.
Focus: Improving Competitive Position vis-à-vis the Five Forces Focus requires that a firm
have either a low-cost position with its strategic target, high differentiation, or both. As we
discussed with regard to cost and differentiation strategies, these positions provide defenses
against each competitive force. Focus is also used to select niches that are least vulnerable
to substitutes or where competitors are weakest.
Let’s look at our examples to illustrate some of these points. First, by providing a platform
for a targeted customer group, businesspeople, to share key work information, LinkedIn
insulated itself from rivalrous pressure from existing social networks, such as Facebook. It
also felt little threat from new generalist social networks, such as Google +. Similarly, the
new focus of Marlin Steel lessened the power of buyers since the company provides specialized products. Also, it is insulated from competitors, which manufacture the commodity
products Marlin used to produce.
Potential Pitfalls of Focus Strategies Potential pitfalls of focus strategies include:
• Cost advantages may erode within the narrow segment. The advantages of a cost focus strategy may be fleeting if the cost advantages are eroded over time. For example, early pioneers in online education, such as the University of Phoenix, have faced increasing challenges as traditional universities have entered with their own online programs that allow them to match the cost benefits associated with online delivery systems. Similarly, other firms have seen their profit margins drop as competitors enter their product segment.
• Even product and service offerings that are highly focused are subject to competition from new entrants and from imitation. Some firms adopting a focus strategy may enjoy temporary advantages because they select a small niche with few rivals. However, their advantages may be short-lived. A notable example is the multitude of dot-com firms that specialize in very narrow segments such as pet supplies, ethnic foods, and vintage automobile accessories. The entry barriers tend to be low, there is little buyer loyalty, and competition becomes intense. And since the marketing strategies and technologies employed by most rivals are largely nonproprietary, imitation is easy. Over time, revenues fall, profits margins are squeezed, and only the strongest players survive the shakeout.
• Focusers can become too focused to satisfy buyer needs. Some firms attempting to attain advantages through a focus strategy may have too narrow a product or service. Consider many retail firms. Hardware chains such as Ace and True Value are losing market share to rivals such as Lowe’s and Home Depot that offer a full line of home and garden equipment and accessories. And given the enormous purchasing power of the national chains, it would be difficult for such specialty retailers to attain parity on costs.
Combination Strategies: Integrating Overall Low Cost and Differentiation
Perhaps the primary benefit to firms that integrate low-cost and differentiation strategies is
the difficulty for rivals to duplicate or imitate.45 This strategy enables a firm to provide two
types of value to customers: differentiated attributes (e.g., high quality, brand identification,
reputation) and lower prices (because of the firm’s lower costs in value-creating activities).
The goal is thus to provide unique value to customers in an efficient manner.46 Some firms
are able to attain both types of advantages simultaneously.47 For example, superior quality can
lead to lower costs because of less need for rework in manufacturing, fewer warranty claims,
a reduced need for customer service personnel to resolve customer complaints, and so forth.
Thus, the benefits of combining advantages can be additive, instead of merely involving tradeoffs. Next, we consider four approaches to combining overall low cost and differentiation.
Exploiting the Profit Pool Concept for Competitive Advantage A profit pool is defined
as the total profits in an industry at all points along the industry’s value chain.51 Although
the concept is relatively straightforward, the structure of the profit pool can be complex.52
The potential pool of profits will be deeper in some segments of the value chain than in
others, and the depths will vary within an individual segment. Segment profitability may
vary widely by customer group, product category, geographic market, or distribution channel. Additionally, the pattern of profit concentration in an industry is very often different
from the pattern of revenue generation. Strategy Spotlight 5.4 outlines how airlines have
expanded the profit pools of their market by adding fees for a variety of services.
Integrated Overall Low-Cost and Differentiation Strategies: Improving Competitive Position
vis-à-vis the Five Forces Firms that successfully integrate both differentiation and cost
advantages create an enviable position. For example, Walmart’s integration of information
systems, logistics, and transportation helps it to drive down costs and provide outstanding
product selection. This dominant competitive position serves to erect high entry barriers
to potential competitors that have neither the financial nor physical resources to compete
head-to-head. Walmart’s size—with over $482 million in sales in 2016—provides the chain
with enormous bargaining power over suppliers. Its low pricing and wide selection reduce
the power of buyers (its customers), because there are relatively few competitors that can
provide a comparable cost/value proposition. This reduces the possibility of intense headto-head rivalry, such as protracted price wars. Finally, Walmart’s overall value proposition
makes potential substitute products (e.g., Internet competitors) a less viable threat.
Pitfalls of Integrated Overall Cost Leadership and Differentiation Strategies The pitfalls of
integrated overall cost leadership and differentiation include:
• Failing to attain both strategies and possibly ending up with neither, leaving the
firm “stuck in the middle.” A key issue in strategic management is the creation of
competitive advantages that enable a firm to enjoy above-average returns. Some firms
may become stuck in the middle if they try to attain both cost and differentiation
advantages. As mentioned earlier in this chapter, mainline supermarket chains find
themselves stuck in the middle as their cost structure is higher than discount retailers
offering groceries and their products and services are not seen by consumers as being
as valuable as those of high-end grocery chains, such as Whole Foods.
• Underestimating the challenges and expenses associated with coordinating value-creating
activities in the extended value chain. Integrating activities across a firm’s value chain
with the value chain of suppliers and customers involves a significant investment in
financial and human resources. Firms must consider the expenses linked to technology
investment, managerial time and commitment, and the involvement and investment
required by the firm’s customers and suppliers. The firm must be confident that it can
generate a sufficient scale of operations and revenues to justify all associated expenses.
• Miscalculating sources of revenue and profit pools in the firm’s industry. Firms may
fail to accurately assess sources of revenue and profits in their value chain. This can
occur for several reasons. For example, a manager may be biased due to his or her
functional area background, work experiences, and educational background. If the
manager’s background is in engineering, he or she might perceive that proportionately
greater revenue and margins were being created in manufacturing, product, and
process design than a person whose background is in a “downstream” value-chain
activity such as marketing and sales. Or politics could make managers “fudge” the
numbers to favor their area of operations. This would make them responsible for a
greater proportion of the firm’s profits, thus improving their bargaining position.