Cost Leadership

Differentiation And Cost Leadership Or Cost Leadership?

by Paul Simister on November 21, 2020

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.
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The downside is that weak competitors can make the firm complacent and leave it vulnerable to new market entrants that are better managed.
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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.
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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?

in 3 – Your Strategic Positioning, Business Problems And Mistakes

The Experience Curve & The Impact On Innovation

by Paul Simister on November 17, 2020

I’ve written before about the importance of the experience curve for cost management and the importance to manage it actively rather than hoping that more experience automatically leads to lower costs.

The Impact Of The Experience Curve On Innovation & Differentiation

I’ve never discussed its impact on differentiation and how focusing on getting the most benefits from the experience curve can undermine customer facing innovation.

Process innovation lies at the heart of the experience curve. As you or your team do something repeatedly, then you find better or quicker ways to do it and especially if it is a task that you know will be repeated many times.

The first task is to standardise processes so that as much variation in outputs from the system are eliminated as possible and then, once the process is in control, you improve it.

The logic is impeccable and your costs should reduce.

Standardising Outputs Kills Customer Facing Innovation

But standardising outputs (either products or services) so that you can standardise processes kills customer facing innovation.

If you’re following a low cost reduction strategy using the experience curve, you don’t want to hear

“John I’ve got an idea. I think our customers would love it if we just…”

This is a conflict between getting costs lower and pleasing the customer and shows why Michael Porter was right when he warned of the dangers of getting stuck in the middle – caught between a low cost strategy and a differentiation strategy.

What Should You Do About The Experience Curve?

I certainly don’t think you should ignore it. The cost benefits are much too important to leave to chance.

The Experience Curve And A Low Cost Strategy

A business following a low cost strategy must use the experience curve rigorously and set clear targets for efficiency improvements and cost reduction. The aim remains to produce a good enough product and sell it for a low price. Differentiated niche players will bring out improved products and services will either move along the value curve or even shift it. The competitive response of a low cost competitor who has exploited the experience curve effects is to reduce prices. Yes you have to give up some of your hard fought margins but this is the nature of competition.

The Experience Curve And Differentiation Strategy

I also believe that a business following a differentiation strategy needs to pay attention to managing for the experience curve cost savings and in particular standardising systems and processes so that important customer benefits are delivered consistently and reliably.

But the differentiator needs to actively manage the trade-off between keeping an eye on costs and either losing a differentiation advantage it already has or letting a competitor create a new key success factor which has the potential to transform the market.

Sometimes it will be better to make small, frequent, incremental changes which put the experience curve back to stage 1. Other times it will better to harvest cost savings for a while and then take a bigger, step change in product or service functionality.

It’s hard to generalise for differentiators because it depends on what competitors are doing, how customer needs are changing, the change in the product or service and the ability of the business to manage change and speed down the early stages of the experience curve.

Using The Value Disciplines As A Guide To Innovation

Michael Treacy and Fred Wiersema’s ideas on value disciplines are useful to fall back on when thinking about balancing innovation and the experience curve.

If you’re following an Operation Excellence strategy, the idea is to provide reliable products at a competitive price. You’re going to want to concentrate on extracting a lot of benefits from the experience curve and when you do change products, you’ll hope that your process excellence will give you a cost advantage provided you’re drawing on well established capabilities.

If you’re following a Customer Intimacy strategy, then your focus is very much on how much of an impact any innovation in product or service can have on customers. You’ll already have developed skills at customising products and services to meet the specific needs of particular customers. If customer benefits are high, then you’re likely to change quickly.

If you’re following a Product Leadership strategy, then the temptation to keep changing will be high because the reputation of the business relies on having products that are hot, preferably red hot. However there is a trade-off since you may be prepared to put off small incremental changes to make bigger “next generation” leaps that create so much publicity. Apple is a very good example of a Product leader business.

The Experience Curve & Innovation

Strategy is about making the right call on the big decisions. Sometimes it’s not easy which is why the rewards of getting the decision right are so big and why many companies find themselves stuck in the middle.

My purpose is to help you make the conscious decision.

Although my main interest is on differentiation to create unique customer value, you can’t shy away from managing costs professionally. The experience curve must not be ignored.

in 3 – Your Strategic Positioning

Stuck In The Middle Of Porter’s Generic Strategies

by Paul Simister on November 17, 2020

Harvard professor and world famous business strategist Michael Porter has a simple view to business and how you can generate superior returns from your business – the generic strategies – but you can get stuck in the middle, not one thing or the other.

These ideas were introduced in the book Competitive Strategy by Michael Porter.

The Keys To Successful Competitive Strategy

Either:

Work in a business which is an attractive industry – this is a business that is well positioned against the five competitive forces that Porter identified (threat of new entrants, threat of substitutes, buyer power, supplier power and intensity of competition).
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Have a competitive advantage.

Michael Porter & The Generic Strategies

And when it comes to competitive advantage, Porter was equally simple because your competitive advantage can either be:

From being the lowest cost operator supplier acceptable goods and services at a reasonable price (and having the ability to beat anyone else on price if necessary)
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From winning buyer preferences based on providing a product or service which is differentiated.

Those two cost advantages can either be applied to the broad market or to narrow focused or niched markets.

The Danger Of Being Stuck In The Middle

Unfortunately many businesses fall into the trap of being “stuck in the middle” of the generic strategies of differentiation and cost leadership.

They don’t offer the high value for money and distinctive product or service that you get from a differentiated business.

And they don’t offer the low prices that can come from buying from the cost leader.

It happens because the business managers don’t know that they have to choose or think that they can be both.

Effectively being stuck in the middle comes from trying to compromise and it creates a muddle.

A muddle for your customers who don’t really know what you stand for or what to expect from you.

And a muddle for your employee who don’t understand the priorities of their work performance.

Other Stuck In The Middle Concepts

Stuck in the middle in this strategic context does not mean:

Being in the middle of a value chain from raw material supplier at one end to end user of final product at the other. It can be uncomfortable being squeezed by big suppliers and big buyers but that’s even more reason to follow a cost leadership or differentiation strategy.
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Nor does it mean being stuck in mid market between the premium priced luxury products and the low-priced economy brands although that can also be uncomfortable if it’s not clear what your business stands for. This mid market position is sometimes combined with Porter’s stuck in the middle concept but it is a big simplification of what he’s trying to say. There is no reason why a business can’t have a very distinct and differentiated product offering and charge mid market prices for example in cars, think of the Mazda MX5 sports car.

How A Business Gets Stuck In The Middle

A stuck in the middle position happens when a business designed to be low cost starts adding little extra frills which don’t add a corresponding amount to the customer value of a product.

The business suffers the cost, the customer doesn’t get the benefit.

Or when a differentiated business comes under pressure on prices – perhaps there has been a market disruption from new technology or an ultra low-priced competitor from overseas – and starts cutting costs in areas which damage the differentiation advantage.

What To Do If Your Business Is Stuck In the Middle

If you think that your business is stuck in the middle – or heading in that direction – then you need to get to grips with your business strategy.

You need to decide what your business is and isn’t.

You need to decide who your business will sell to and who it won’t.

You need to decide what your business will sell and what it won’t.

Strategy is about making wise choices and then having the courage and conviction to follow through and commit to turning words and ideas into action.

The Role Of The Value Chain In Creating Competitive Advantage

In his follow-up book, Competitive Advantage, Michael Porter introduced the concept of value chain analysis to help you to analyse, understand and create competitive advantage so that a business isn’t stuck in the middle.

The value chain is an important technique which helps you to focus on advantage based on differentiation or cost leadership.

in 3 – Your Strategic Positioning, Business Problems And Mistakes