In his book Competitive Advantage, management guru Michael Porter argues that although organisations can have a myriad of strengths and weaknesses relative to their competitors, they essentially compete in one of two ways: on the basis of cost or differentiation. In addition they can have customer focus.
It is important to recognise that sustainable advantage based on leadership in key cost-structure elements does not necessarily imply a low quality of service, or a competitive stance based on low price. The key objective is to deliver those value-added elements that matter most to customers, at a cost consistently below that of competitors. Thus, even a very expensive service (such as on-the-spot replacement of travellers’ cheques) via extremely expensive technology such as satellite up-links may still be provided at a lower cost than that of competitors. A lower-cost structure means efficient cost control and it does not necessarily imply low price. Instead an efficient lower-cost structure should provide scope for increased margins. Margins are important in mass-markets, as well as luxury products or services.
Economies of scale have been a major reason why the largest companies (in some industries) are able to produce goods or provide services much more cheaply than their smaller rivals. Fixed costs can be spread over more units of output, so the cost per unit falls. This explains why supermarkets, relative to local grocers, are able to charge lower prices on high volume items.
Accumulation of experience (sometimes called “learning curve” effects) occurs as organisations repeat a process, and become able to do things better and faster. The benefits of experience are most difficult for competitors to duplicate when they relate to the interaction of teams of people undertaking complex tasks; ways of thought and habits of teamwork may be very hard to transplant to another organisation. For example, a corporate finance team working for an investment bank is likely to have developed expertise in certain areas, such as mergers and acquisitions, as well as across certain industries or sectors, such as insurance or health. Learning curve effects are likely to relate not only to their specialist areas of expertise but also to the complex patterns of interaction they have developed between themselves.
If both scale advantages and experience advantages exist, the resulting cost advantage can provide a substantial barrier for other organisations to overcome. However, advantages conferred by experience gains and by size are not automatic:
- Organisations have to work to make use of the learning
- They will only be able to maximise their gain from experience if the learning can be kept proprietary
- Experience or scale benefits must exist in an important value-creating function of the organisation. It is relative scale or experience in relation to key functions - not in relation to overall sales volume - which gives an ability to build competitive advantage around a low-cost position
- Competitors may enter markets or industries and treat short-term losses as the entry costs of investment, if the long-term rewards are perceived by them to be attractive and certain enough
- Scale must provide cost reductions which more than offset the cost increases which size can also bring. The costs of complexity in organisations can rise sharply with the size of a company. In the 1990s, Nokia, a Finnish telecommunications company, grew from a national to a global company with sales exceeding $30 billion and over 50,000 employees. The increase in cost of co-ordinating and controlling its resources, including its human resources or employees, might have been proportionately greater than the increase in firm size
In addition to scale and experience, cost leadership can come from many other routes. Organisations can base their cost leadership positions on superior technology; on superior operational logistics (especially if these can optimise key cost elements such as salesperson time); and from a cost-cutting culture, where all staff members are dedicated to the elimination of waste.
There are many different routes by which organisations can create added value founded on differentiation. The means for differentiation are peculiar to each industry.
Differentiation can be based on the product itself, the delivery system by which it is sold, the marketing approach as well as other factors. The logic of a differentiation strategy is that a firm chooses attributes with which to differentiate itself, that are different from its rivals. Some of the most important ways in which organisations differentiate their products or services are:
- By pursuing strong branding – Branding is far from cost-free; to maintain a brand involves heavy investment in advertising. But it helps define a competitive space in which image, not price, is the prime distinction between products, such as with designer clothing.
- By employing a highly specialised or skilled sales force – This is hard for rivals to replicate. Drug companies have traditionally employed specialised salespeople, with high levels of training, to call on doctors to promote their prescription drugs. This entry barrier explains why major newcomers to drug production in recent years have been companies selling unbranded ‘generic’ drugs (exact chemical copies of brand-name drugs whose patents have expired); newcomers have tried to fight the established companies by changing the rules of the game
- By dominating niche markets – Rivals could challenge organisations here only at a cost which would not be justified given the small total market size
- By cultivating specialist knowledge or skills – The knowledge may be overt or it may be embodied in organisational routines and practices which are hard for others to duplicate, such as ability to outperform competitors by developing very fast response times
- By investing in intellectual property – Using patents and other legislative protection to protect that investment. The extent to which this succeeds is dependent on legislation in any particular country, however
- By pursuing exclusivity in links to the distribution network – The most obvious case of this is when companies attempt to purchase their distributors so as to shut out rival products. But it can also happen less formally
The scope for a company to pursue differentiation strategies will only exist if there are groups of customers with very distinct needs, who are willing to pay a premium to have those needs well met. There must, in other words, be distinct market segments. These segments may be large, or may only constitute a fairly small portion of the total market for the industry.
We can see that there are many ways a firm can pursue a differentiation strategy, and firms can even combine one or more means of differentiation at any one time. Also, firms often adopt “hybrid” strategies, competing on the basis of cost and differentiation.
There is a strong conceptual link between the idea of customer focus, and the idea of specialisation; both flow from a recognition that there are some customers with distinctive needs, and that the organisation should seek to serve those needs. But it is possible to seek advantage from customer focus (serving a carefully defined range of the potential consumers in an industry) in the context of either a strategy based on highly specialised knowledge and skills, or one based on the pursuit of cost superiority.
- A key competitive advantage of direct insurers (who sell insurance plans directly to the end consumer, either by phone or on-line, without a broker or agent) is the ability to choose exactly which customers they wish to accept. This enables them to reduce the claim costs of the best insurance risks (such as older drivers who are more careful and less likely to drive expensive sports cars). This is a low-cost strategy, underpinned by the tight selection of the customers to be served, i.e. a cost focus strategy. It is hard for conventional insurers to select risks in this way, because of their need to serve intermediaries who make their living by catering to a wide variety of risks within a limited geographical area.
- Aero engine companies such as the UK’s Rolls Royce and the US’s General Electric have to seek the widest possible market for their engines, in order to recoup their enormous research and development costs. The number of potential purchasers of expensive aircraft worldwide is limited, and it would not be feasible to produce for only some customers (for example, to seek to be a purely ‘national’ engine producer). This is a differentiation strategy, although one aimed at a broad range of customer segments internationally.
There are many different ways of competing in the same industry. Cost-based competition is an immensely powerful tool; but there is normally only room for one or two cost leaders. Cost leaders do not have to compete on price; they may choose to invest their higher margins in higher levels of service, the creation of more flexible manufacturing facilities, faster response times, more advertising, and so on.
Having obtained a lead, cost leaders have the freedom (unlike their rivals) to choose how to price, position and support their products. Alternatively, differentiation and focus offer a route by which many organisations can co-exist. In many industries, and for most smaller competitors, they are a key to creating competitive advantage. However, organisations do not have a totally free hand in making such decisions. Their own history and size, and the nature of the sector in which they operate, shape the choices they can make.