Three of the most widely read books on competitive analysis in the 1980s were Michael Porter's Competitive Strategy, Competitive Advantage, and Competitive Advantage of Nations. In his various books, Porter developed three generic strategies that, he argues, can be used singly or in combination to create a defendable position and to outperform competitors, whether they are within an industry or across nations. Porter states that the strategies are generic because they are applicable to a large variety of situations and contexts. The strategies are (1) overall cost leadership; (2) differentiation; and (3) focus on a particular market niche. The generic strategies provide direction for firms in designing incentive systems, control procedures, and organizational arrangements. Following is a description of this work.
Overall cost leadership requires firms to develop policies aimed at becoming and remaining the lowest-cost producer and/or distributor in the industry. Company strategies aimed at controlling costs include construction of efficient-scale facilities, tight control of costs and overhead, avoidance of marginal customer accounts, minimization of operating expenses, reduction of input costs, tight control of labor costs, and lower distribution costs. The low-cost leader gains competitive advantage by getting its costs of production or distribution lower than those of the other firms in its market. The strategy is especially important for firms selling unbranded commodities such as beef or steel.
Figure 1 shows the competitive advantage firms may achieve through cost leadership. C is the original cost of production. C is the new cost of production. SP is the original selling price. SP is the new selling price. P is the original profit margin. P is the new profit margin.
If we assume our firm and the other competitors are producing the product for a cost of C and selling it at SP, we are all receiving a profit of P. As cost leader, we are able to lower our cost to C while the competitors remain at C. We now have two choices as to how to take advantage of our reduced costs.
Overall cost leadership is not without potential problems. Two or more firms competing for cost leadership may engage in price wars that drive profits to very low levels. Ideally, a firm using a cost leader strategy will develop an advantage that is not easily copied by others. Cost leaders also must maintain their investment in state-of-the-art equipment or face the possible entry of more cost-effective competitors. Major changes in technology may drastically change production processes so that previous investments in production technology are no longer advantageous. Finally, firms may become so concerned with maintaining low costs that needed changes in production or marketing are overlooked. The strategy may be more difficult in a dynamic environment because some of the expenses that firms may seek to minimize are research and development costs or marketing research costs, yet these are expenses the firm may need to incur in order to remain competitive.
The second generic strategy, differentiating the product or service, requires a firm to create something about its product or service that is perceived as unique throughout the industry. Whether the features are real or just in the mind of the customer, customers must perceive the product as having desirable features not commonly found in competing products. The customers also must be relatively price-insensitive. Adding product features means that the production or distribution costs of a differentiated product may be somewhat higher than the price of a generic, non-differentiated product. Customers must be willing to pay more than the marginal cost of adding the differentiating feature if a differentiation strategy is to succeed.
Differentiation may be attained through many features that make the product or service appear unique. Possible strategies for achieving differentiation may include:
Differentiation does not allow a firm to ignore costs; it makes a firm's products less susceptible to cost pressures from competitors because customers see the product as unique and are willing to pay extra to have the product with the desirable features. Differentiation can be achieved through real product features or through advertising that causes the customer to perceive that the product is unique.
Differentiation may lead to customer brand loyalty and result in reduced price elasticity. Differentiation may also lead to higher profit margins and reduce the need to be a low-cost producer. Since customers see the product as different from competing products and they like the product features, customers are willing to pay a premium for these features. As long as the firm can increase the selling price by more than the marginal cost of adding the features, the profit margin is increased. Firms must be able to charge more for their differentiated product than it costs them to make it distinct, or else they may be better off making generic, undifferentiated products. Firms must remain sensitive to cost differences. They must carefully monitor the incremental costs of differentiating their product and make certain the difference is reflected in the price.
Firms pursuing a differentiation strategy are vulnerable to different competitive threats than firms pursuing a cost leader strategy. Customers may sacrifice features, service, or image for cost savings. Customers who are price sensitive may be willing to forgo desirable features in favor of a less costly alternative. This can be seen in the growth in popularity of store brands and private labels. Often, the same firms that produce name-brand products produce the private label products. The two products may be physically identical, but stores are able to sell the private label products for a lower price because very little money was put into advertising in an effort to differentiate the private label product.
Imitation may also reduce the perceived differences between products when competitors copy product features. Thus, for firms to be able to recover the cost of marketing research or R&D, they may need to add a product feature that is not easily copied by a competitor.
A final risk for firms pursuing a differentiation strategy is changing consumer tastes. The feature that customers like and find attractive about a product this year may not make the product popular next year. Changes in customer tastes are especially obvious in the apparel industry. Polo Ralph Lauren has been a very successful brand in the fashion industry. However, some younger consumers have shifted to Tommy Hilfiger and other youth-oriented brands.
Ralph Lauren, founder and CEO, has been the guiding light behind his company's success. Part of the firm's success has been the public's association of Lauren with the brand. Ralph Lauren leads a high-profile lifestyle of preppy elegance. His appearance in his own commercials, his Manhattan duplex, his Colorado ranch, his vintage car collection, and private jet have all contributed to the public's fascination with the man and his brand name. This image has allowed the firm to market everything from suits and ties to golf balls. Through licensing of the name, the Lauren name also appears on sofas, soccer balls, towels, table-ware, and much more.
Can forms of competitive advantage be combined? Porter asserts that a successful strategy requires a firm to aggressively stake out a market position, and that different strategies involve distinctly different approaches to competing and operating the business. An organization pursuing a differentiation strategy seeks competitive advantage by offering products or services that are unique from those offered by rivals, either through design, brand image, technology, features, or customer service. Alternatively, an organization pursuing a cost leadership strategy attempts to gain competitive advantage based on being the overall low-cost provider of a product or service. To be "all things to all people" can mean becoming "stuck in the middle" with no distinct competitive advantage. The difference between being "stuck in the middle" and successfully pursuing combination strategies merits discussion. Although Porter describes the dangers of not being successful in either cost control or differentiation, some firms have been able to succeed using combination strategies.
Research suggests that, in some cases, it is possible to be a cost leader while maintaining a differentiated product. Southwest Airlines has combined cost cutting measures with differentiation. The company has been able to reduce costs by not assigning seating and by eliminating meals on its planes. It has then been able to promote in its advertising that one does not get tasteless airline food on its flights. Its fares have been low enough to attract a significant number of passengers, allowing the airline to succeed.
Another firm that has pursued an effective combination strategy is Nike. When customer preferences moved to wide-legged jeans and cargo pants, Nike's market share slipped. Competitors such as Adidas offered less expensive shoes and undercut Nike's price. Nike's stock price dropped in 1998 to half its 1997 high. However, Nike reported a 70 percent increase in earnings for the first quarter of 1999 and saw a significant rebound in its stock price. Nike achieved the turn-around by cutting costs and developing new, distinctive products. Nike reduced costs by cutting some of its endorsements. Company research suggested the endorsement by the Italian soccer team, for example, was not achieving the desired results. Michael Jordan and a few other "big name" endorsers were retained while others, such as the Italian soccer team, were eliminated, resulting in savings estimated at over $100 million. Firing 7 percent of its 22,000 employees allowed the company to lower costs by another $200 million, and inventory was reduced to save additional money. While cutting costs, the firm also introduced new products designed to differentiate Nike's products from those of the competition.
Some industry environments may actually call for combination strategies. Trends suggest that executives operating in highly complex environments such as health care do not have the luxury of choosing exclusively one strategy over the other. The hospital industry may represent such an environment, as hospitals must compete on a variety of fronts. Combination (i.e., more complicated) strategies are both feasible and necessary to compete successfully. For instance, DRG-based reimbursement (diagnosis related groups) and the continual lowering of reimbursement ceilings have forced hospitals to compete on the basis of cost. At the same time, many of them jockey for position with differentiation based on such features as technology and birthing rooms. Thus, many hospitals may need to adopt some form of hybrid strategy in order to compete successfully, according to Walters and Bhuian.
The generic strategies of cost leadership and differentiation are oriented toward industry-wide recognition. The final generic strategy, focusing (also called niche or segmentation strategy), involves concentrating on a particular customer, product line, geographical area, channel of distribution, stage in the production process, or market niche. The underlying premise of the focus strategy is that a firm is better able to serve a limited segment more efficiently than competitors can serve a broader range of customers. Firms using a focus strategy simply apply a cost leader or differentiation strategy to a segment of the larger market. Firms may thus be able to differentiate themselves based on meeting customer needs, or they may be able to achieve lower costs within limited markets. Focus strategies are most effective when customers have distinctive preferences or specialized needs.
A focus strategy is often appropriate for small, aggressive businesses that do not have the ability or resources to engage in a nationwide marketing effort. Such a strategy may also be appropriate if the target market is too small to support a large-scale operation. Many firms start small and expand into a national organization. For instance, Wal-Mart started in small towns in the South and Midwest. As the firm gained in market knowledge and acceptance, it expanded through-out the South, then nationally, and now internationally. Wal-Mart started with a focused cost leader strategy in its limited market, and later was able to expand beyond its initial market segment.
A firm following the focus strategy concentrates on meeting the specialized needs of its customers. Products and services can be designed to meet the needs of buyers. One approach to focusing is to service either industrial buyers or consumers, but not both. Martin-Brower, the third-largest food distributor in the United States, serves only the eight leading fast-food chains. With its limited customer list, Martin-Brower need only stock a limited product line; its ordering procedures are adjusted to match those of its customers; and its warehouses are located so as to be convenient to customers.
Firms utilizing a focus strategy may also be better able to tailor advertising and promotional efforts to a particular market niche. Many automobile dealers advertise that they are the largest volume dealer for a specific geographic area. Other car dealers advertise that they have the highest customer satisfaction scores within their defined market or the most awards for their service department.
Firms may be able to design products specifically for a customer. Customization may range from individually designing a product for a customer to allowing customer input into the finished product. Tailor-made clothing and custom-built houses include the customer in all aspects of production, from product design to final acceptance. Key decisions are made with customer input. However, providing such individualized attention to customers may not be feasible for firms with an industry-wide orientation.
Other forms of customization simply allow the customer to select from a menu of predetermined options. Burger King advertises that its burgers are made "your way," meaning that the customer gets to select from the predetermined options of pickles, lettuce, and so on. Similarly, customers are allowed to design their own automobiles within the constraints of predetermined colors, engine sizes, interior options, and so forth.
Potential difficulties associated with a focus strategy include a narrowing of differences between the limited market and the entire industry. National firms routinely monitor the strategies of competing firms in their various submarkets. They may then copy the strategies that appear particularly successful. The national firm, in effect, allows the focused firm to develop the concept, then the national firm may emulate the strategy of the smaller firm or acquire it as a means of gaining access to its technology or processes. Emulation increases the ability of other firms to enter the market niche while reducing the cost advantages of serving the narrower market.
Market size is always a problem for firms pursing a focus strategy. The targeted market segment must be large enough to provide an acceptable return so that the business can survive. For instance, ethnic restaurants are often unsuccessful in small U.S. towns, since the population base that enjoys Japanese or Greek cuisine is too small to allow the restaurant operator to make a profit. Likewise, the demand for an expensive, upscale restaurant is usually not sufficient in a small town to make its operation economically feasible.
Another potential danger for firms pursuing a focus strategy is that competitors may find submarkets within the target market. In the past, United Parcel Service (UPS) solely dominated the package delivery segment of the delivery business. Newer competitors such as Federal Express and Roadway Package Service (RPS) have entered the package delivery business and have taken customers away from UPS. RPS contracts with independent drivers in a territory to pick up and deliver packages, while UPS pays unionized wages and benefits to its drivers. RPS started operations in 1985 with 36 package terminals. By 1999 it was a $1 billion company with 339 facilities.
Porter asserts that these generic competitive strategies were not only relevant for the old economy, but are just as vital today. Indeed, he goes on to say that terms such as "old economy" and "new economy" may be misguided, and the concept of a firm's Internet operation as a stand-alone entity preclude the firm from garnering important synergies. Furthermore, the Internet may enhance a firm's opportunities for achieving or strengthening a distinctive strategic positioning. Therefore, effective strategy formulation at the business level should pay off, not in spite of the Internet, but in concert with it.
Porter describes how companies can set themselves apart in at least two ways: operational effectiveness (doing the same activities as competitors but doing them better) and strategic positioning (doing things differently and delivering unique value for customers). "The Internet affects operational effectiveness and strategic positioning in very different ways. It makes it harder for companies to sustain operational advantages, but it opens new opportunities for achieving or strengthening a distinctive strategic positioning." Although the Internet is a powerful tool for enhancing operational effectiveness, these enhancements alone are not likely to be sustained because of copying by rivals. This state of affairs elevates the importance of defining for the firm a unique value proposition. Internet technology can be a complement to successful strategy, but it is not sufficient. "Frequently, in fact, Internet applications address activities that, while necessary, are not decisive in competition, such as informing customers, processing transactions, and procuring inputs. Critical corporate assets—skilled personnel, proprietary product technology, efficient logistical systems—remain intact, and they are often strong enough to preserve existing competitive advantages."
Consistent with the earlier discussion regarding combination strategies, Kim, Nam, and Stimpert found in their study of e-businesses that firms pursuing a hybrid strategy of cost leadership and differentiation exhibited the highest performance. These authors concluded that cost leadership and differentiation must often be combined to be successful in e-business.
Porter's generic business strategies provide a set of methods that can be used singly or in combination to create a defendable business strategy. They also allow firms that use them successfully to gain a competitive advantage over other firms in the industry. Firms either strive to obtain lower costs than their competitors or to create a perceived difference between their product and the products of competitors. Firms can pursue their strategy on a national level or on a more focused, regional basis.
Clearly, Michael Porter's work has had a remarkable impact on strategy research and practice. The annual Porter Prize, akin to the Deming Prize, was established in 2001 in Japan to recognize that nation's leading companies in terms of strategy. Porter's ideas have stood the test of time and appear to be relevant both for profit-seeking enterprises and not-for-profit institutes in a variety of international settings. Torgovicky, Goldberg, Shvarts, and Bar Dayan have found a relationship between business strategy and performance measures in an ambulatory health care system in Israel, strengthening Porter's original theory about the non-viability of the stuck-in-the-middle strategy, and suggesting the applicability of Porter's generic strategies to not-for-profit institutes.
Joe G. Thomas
Revised by Bruce A. Walters
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