A pitfall to avoid in pursuing a differentiation strategy is

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CHAPTER 5

The Five Generic Competitive Strategies

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Learning Objectives THIS CHAPTER WILL HELP YOU UNDERSTAND:

LO 1 What distinguishes each of the five generic strategies and why some of these strategies work better in certain kinds of competitive conditions than in others.

LO 2 The major avenues for achieving a competitive advantage based on lower costs.

LO 3 The major avenues to a competitive advantage based on differentiating a company’s product or service offering from the offerings of rivals.

LO 4 The attributes of a best-cost provider strategy—a hybrid of low-cost provider and differentiation strategies.

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Strategy 101 is about choices: You can’t be all things to all people.

Michael E. Porter—Professor, author, and cofounder of Monitor Consulting

Strategy is all about combining choices of what to do and what not to do into a system that creates the requisite fit between what the environment needs and what the company does.

Costas Markides—Professor and consultant

I learnt the hard way about positioning in business, about catering to the right segments.

Shaffi Mather—Social entrepreneur

A company can employ any of several basic approaches to competing successfully and gaining a competitive advantage over rivals, but they all involve delivering more value to customers than rivals or delivering value more efficiently than rivals (or both). More value for customers can mean a good product at a lower price, a superior product worth paying more for, or a best-value offering that represents an attractive combination of price, features, service, and other appealing attributes. Greater efficiency means delivering a given level of value to customers at a lower cost to the company. But whatever approach to delivering value the company takes, it nearly always requires performing value chain activities differently than rivals and building competitively valuable resources and capabilities that rivals cannot readily match or trump.

This chapter describes the five generic competitive strategy options. Which of the five to employ is a company’s first and foremost choice in crafting an overall strategy and beginning its quest for competitive advantage.

TYPES OF GENERIC COMPETITIVE STRATEGIES

LO 1

What distinguishes each of the five generic strategies and why some of these strategies work better in certain kinds of competitive conditions than in others.

A company’s competitive strategy deals exclusively with the specifics of management’s game plan for competing successfully—its specific efforts to position itself in the marketplace, please customers, ward off competitive threats, and achieve a particular kind of competitive advantage. The chances are remote that any two companies—even companies in the same industry—will employ competitive strategies that are exactly alike in every detail. However, when one strips away the details to get at the real substance, the two biggest factors that distinguish one competitive strategy from another boil down to (1) whether a company’s market target is broad or narrow and (2) whether the company is pursuing a competitive advantage linked to lower costs or differentiation. These two factors give rise to five competitive strategy options, as shown in Figure 5.1 and listed next.1

FIGURE 5.1 The Five Generic Competitive Strategies

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Source: This is an expanded version of a three-strategy classification discussed in Michael E. Porter, Competitive Strategy (New York: Free Press, 1980).

1. A low-cost provider strategy—striving to achieve lower overall costs than rivals on comparable products that attract a broad spectrum of buyers, usually by underpricing rivals.

2. A broad differentiation strategy—seeking to differentiate the company’s product offering from rivals’ with attributes that will appeal to a broad spectrum of buyers.

3. A focused low-cost strategy—concentrating on the needs and requirements of a narrow buyer segment (or market niche) and striving to meet these needs at lower costs than rivals (thereby being able to serve niche members at a lower price).

4. A focused differentiation strategy—concentrating on a narrow buyer segment (or market niche) and outcompeting rivals by offering niche members customized attributes that meet their tastes and requirements better than rivals’ products.

5. A best-cost provider strategy—striving to incorporate upscale product attributes at a lower cost than rivals. Being the “best- cost” producer of an upscale, multifeatured product allows a company to give customers more value for their money by underpricing rivals whose products have similar upscale, multifeatured attributes. This competitive approach is a hybrid strategy that blends elements of the previous four options in a unique and often effective way. The remainder of this chapter explores the ins and outs of these five generic competitive strategies and how they differ.

LOW-COST PROVIDER STRATEGIES

LO 2 The major avenues for achieving a competitive advantage based on lower costs.

Striving to achieve lower overall costs than rivals is an especially potent competitive approach in markets with many price- sensitive buyers. A company achieves low-cost leadership when it becomes the industry’s lowest-cost provider rather than just being one of perhaps several competitors with comparatively low costs. A low-cost provider’s foremost strategic objective is meaningfully lower costs than rivals—but not necessarily the absolutely lowest possible cost. In striving for a cost advantage over rivals, company managers must incorporate features and services that buyers consider essential. A product offering that is too frills-free can be viewed by consumers as offering little value regardless of its pricing.

CORE CONCEPT A low-cost provider’s basis for competitive advantage is lower overall costs than competitors. Successful low-cost leaders, who have the lowest industry costs, are exceptionally good at finding ways to drive costs out of their businesses and still provide a product or service that buyers find acceptable. A low-cost advantage over rivals can translate into better profitability than rivals attain.

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A company has two options for translating a low-cost advantage over rivals into attractive profit performance. Option 1 is to use the lower-cost edge to underprice competitors and attract price-sensitive buyers in great enough numbers to increase total profits. Option 2 is to maintain the present price, be content with the present market share, and use the lower-cost edge to earn a higher profit margin on each unit sold, thereby raising the firm’s total profits and overall return on investment.

While many companies are inclined to exploit a low-cost advantage by using option 1 (attacking rivals with lower prices), this strategy can backfire if rivals respond with retaliatory price cuts (in order to protect their customer base and defend against a loss of sales). A rush to cut prices can often trigger a price war that lowers the profits of all price discounters. The bigger the risk that rivals will respond with matching price cuts, the more appealing it becomes to employ the second option for using a low-cost advantage to achieve higher profitability.

A low-cost advantage over rivals can translate into better profitability than rivals attain.

The Two Major Avenues for Achieving a Cost Advantage To achieve a low-cost edge over rivals, a firm’s cumulative costs across its overall value chain must be lower than competitors’ cumulative costs. There are two major avenues for accomplishing this:2

1. Perform value chain activities more cost-effectively than rivals. 2. Revamp the firm’s overall value chain to eliminate or bypass some cost-producing activities.

CORE CONCEPT A cost driver is a factor that has a strong influence on a company’s costs.

Cost-Efficient Management of Value Chain Activities For a company to do a more cost-efficient job of managing its value chain than rivals, managers must diligently search out cost-saving opportunities in every part of the value chain. No activity can escape cost-saving scrutiny, and all company personnel must be expected to use their talents and ingenuity to come up with innovative and effective ways to keep down costs. Particular attention must be paid to a set of factors known as cost drivers that have a strong effect on a company’s costs and can be used as levers to lower costs. Figure 5.2 shows the most important cost drivers. Cost-cutting approaches that demonstrate an effective use of the cost drivers include:

Figure 5.2 Cost Drivers: The Keys to Driving Down Company Costs

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Source: Adapted from Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985).

1. Capturing all available economies of scale. Economies of scale stem from an ability to lower unit costs by increasing the scale of operation. Economies of scale may be available at different points along the value chain. Often a large plant is more economical to operate than a small one, particularly if it can be operated round the clock robotically. Economies of scale may be available due to a large warehouse operation on the input side or a large distribution center on the output side. In global industries, selling a mostly standard product worldwide tends to lower unit costs as opposed to making separate products for each country market, an approach in which costs are typically higher due to an inability to reach the most economic scale of production for each country. There are economies of scale in advertising as well. For example, Anheuser-Busch could afford to pay the $5 million cost of a 30-second Super Bowl ad in 2016 because the cost could be spread out over the hundreds of millions of units of Budweiser that the company sells.

2. Taking full advantage of experience and learning-curve effects. The cost of performing an activity can decline over time as the learning and experience of company personnel build. Learning and experience economies can stem from debugging and mastering newly introduced technologies, using the experiences and suggestions of workers to install more efficient plant layouts and assembly procedures, and the added speed and effectiveness that accrues from repeatedly picking sites for and building new plants, distribution centers, or retail outlets.

3. Operating facilities at full capacity. Whether a company is able to operate at or near full capacity has a big impact on unit costs when its value chain contains activities associated with substantial fixed costs. Higher rates of capacity utilization allow depreciation and other fixed costs to be spread over a larger unit volume, thereby lowering fixed costs per unit. The more capital-intensive the business and the higher the fixed costs as a percentage of total costs, the greater the unit-cost penalty for operating at less than full capacity.

4. Improving supply chain efficiency. Partnering with suppliers to streamline the ordering and purchasing process, to reduce inventory carrying costs via just-in-time inventory practices, to economize on shipping and materials handling, and to ferret out other cost-saving opportunities is a much-used approach to cost reduction. A company with a distinctive competence in cost-efficient supply chain management, such as BASF (the world’s leading chemical company), can sometimes achieve a sizable cost advantage over less adept rivals.

5. Substituting lower-cost inputs wherever there is little or no sacrifice in product quality or performance. If the costs of certain raw materials and parts are “too high,” a company can switch to using lower-cost items or maybe even design the high-cost components out of the product altogether.

6. Using the company’s bargaining power vis-à-vis suppliers or others in the value chain system to gain concessions. Home Depot, for example, has sufficient bargaining clout with suppliers to win price discounts on large-volume purchases.

7. Using online systems and sophisticated software to achieve operating efficiencies. For example, sharing data and production schedules with suppliers, coupled with the use of enterprise resource planning (ERP) and manufacturing execution system (MES) software, can reduce parts inventories, trim production times, and lower labor requirements.

8. Improving process design and employing advanced production technology. Often production costs can be cut by (1) using design for manufacture (DFM) procedures and computer-assisted design (CAD) techniques that enable more integrated and efficient production methods, (2) investing in highly automated robotic production technology, and (3) shifting to a mass- customization production process. Dell’s highly automated PC assembly plant in Austin, Texas, is a prime example of the use of advanced product and process technologies. Many companies are ardent users of total quality management (TQM) systems, business process reengineering, Six Sigma methodology, and other business process management techniques that aim at boosting efficiency and reducing costs.

9. Being alert to the cost advantages of outsourcing or vertical integration. Outsourcing the performance of certain value chain activities can be more economical than performing them in-house if outside specialists, by virtue of their expertise and volume, can perform the activities at lower cost. On the other hand, there can be times when integrating into the activities of either suppliers or distribution-channel allies can lower costs through greater production efficiencies, reduced transaction costs, or a better bargaining position.

10. Motivating employees through incentives and company culture. A company’s incentive system can encourage not only greater worker productivity but also cost-saving innovations that come from worker suggestions. The culture of a company can also spur worker pride in productivity and continuous improvement. Companies that are well known for their cost- reducing incentive systems and culture include Nucor Steel, which characterizes itself as a company of “20,000 teammates,” Southwest Airlines, and Walmart.

Revamping of the Value Chain System to Lower Costs Dramatic cost advantages can often emerge from redesigning the company’s value chain system in ways that eliminate costly work steps and entirely bypass certain cost- producing value chain activities. Such value chain revamping can include:

• Selling direct to consumers and bypassing the activities and costs of distributors and dealers. To circumvent the need for distributors and dealers, a company can (1) create its own direct sales force (which adds the costs of maintaining and supporting a sales force but which may well be cheaper than using independent distributors and dealers to access buyers) and/or (2) conduct sales operations at the company’s website (incurring costs for website operations and shipping may be a substantially cheaper way to make sales than going through distributor–dealer channels). Costs in the wholesale and retail portions of the value chain frequently represent 35 to 50 percent of the final price consumers pay, so establishing a direct sales force or selling online may offer big cost savings.