In his book Competitive Strategy, Michael Porter introduces the idea of generic competitive strategies and says that a business must choose between differentiation and cost leadership or risk being “stuck in the middle”, missing on the high profitability that an effective strategy for one or the other.
Differentiation Or Cost Leadership
Porter argues that businesses face a choice – differentiation or cost leadership over a broad or narrow market – if the firm wants to avoid low profitability that comes from confused customers and employees from a “blurred corporate culture”.
This is because achieving cost leadership normally involves eliminating all those little bits of extra product functionality and customer service that bump up customer value in the eyes of customers looking for a differentiated product because they cost money.
This makes a lot of sense.
Business managers intuitively know that to give the customer more, it’s going to usually cost more.
But then examples started to appear which showed successful businesses which had established a cost leadership position but which were also differentiated.
Quality Is Free
Just as Michael Porter argued that cost leadership and differentiation involved trade-offs that meant you couldn’t do both, it used to be thought that businesses had to choose between low cost and good, consistent quality.
But the total quality movement popularised by Edwards Deming, Philip Crosby and Joseph Juran showed that cost of quality had an inverse relationship. As quality improves, costs didn’t increase as had been expected but reduced.
Differentiation And Cost Leadership
In Michael Porter’s next book, Competitive Advantage, he still warned about the dangers of being stuck in the middle.
“Becoming stuck in the middle is often a manifestation of a firm’s unwillingness to make choices about how to compete. It tries for competitive advantage through every means and achieved none, because achieving different types of competitive advantage usually requires inconsistent actions.” (page 17).
On the next two pages of the book, he softens his stance by admitting that reducing costs does not always mean sacrificing differentiation because using more effective methods and technology may reduce costs and improve differentiation. He goes on to point out that reducing costs from a high position is not the same as achieving a cost leadership position. He looked at this in more detail in What Is Strategy?
Porter identifies three conditions where a business can achieve differentiation and cost leadership:
- When competitors are stuck in the middle and don’t force the business to the point where differentiation and cost leadership are inconsistent. This may be more often than you would expect in local, fragmented markets where businesses don’t have opportunities for big differentials in input costs for materials and labour.
The downside is that weak competitors can make the firm complacent and leave it vulnerable to new market entrants that are better managed.
- When cost is strongly determined by market share or interrelationships. Large economies of scale can give the business a big enough cost advantage to allow it to spend some of its cost savings on elements to differentiate the products and still achieve cost leadership. Interrelationships may arise between elements of the industry value chain which one competitor can take advantage of and the others can’t.
- The business pioneers a major innovation. Innovative new process technologies may lower production costs that allow the business to invest in differentiation factors or product innovation may deliver both cost leadership and differentiation of customer value attributes. Sustaining this innovation advantage is vital because wants it gets into the general market, the business is forced into the differentiation or cost leadership trade-off. It may even find itself at a disadvantage if rival competitors improve the innovation specifically to lower costs or to create extra differentiation.
The Danger Of The Tempting Lure Of Differentiation And Cost Leadership
A business that achieves differentiation and cost leadership is in a very strong position and should be much the most profitable firm in the industry.
This is precisely why I believe that creating a strategy to achieve both is dangerous.
The lure is strong but so are the traps and being stuck in the middle remains a clear and present danger.
I agree with the conclusion Michael Porter came to in Competitive Advantage.
“A firm should always aggressively pursue all cost reduction opportunities that do not sacrifice differentiation. A firm should also pursue all differentiation opportunities that are not costly. Beyond this point, however, a firm should be prepared to choose what its ultimate competitive advantage will be and resolve the trade-offs accordingly.” (page 20 Competitive Advantage by Michael Porter)
The Value Chain And Competitive Advantage
The value chain was created to help businesses find competitive advantage and while the value chain can be criticised, the technique is very useful to look in detail at your business at the activity level and challenge each activity:
- How does this help differentiate our business from competitors in ways that matter to customers?
- How can we reduce costs in this activity without reducing customer value and service?