Example of best cost provider strategy

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CHAPTER 5

The Five Generic Competitive Strategies

© Roy Scott/Ikon Images/SuperStock

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.

• Streamlining operations by eliminating low-value-added or unnecessary work steps and activities. At Walmart, some items supplied by manufacturers are delivered directly to retail stores rather than being routed through Walmart’s distribution centers and delivered by Walmart trucks. In other instances, Walmart unloads incoming shipments from manufacturers’

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trucks arriving at its distribution centers and loads them directly onto outgoing Walmart trucks headed to particular stores without ever moving the goods into the distribution center. Many supermarket chains have greatly reduced in-store meat butchering and cutting activities by shifting to meats that are cut and packaged at the meatpacking plant and then delivered to their stores in ready-to-sell form.

• Reducing materials handling and shipping costs by having suppliers locate their plants or warehouses close to the company’s own facilities. Having suppliers locate their plants or warehouses close to a company’s own plant facilitates just- in-time deliveries of parts and components to the exact workstation where they will be used in assembling the company’s product. This not only lowers incoming shipping costs but also curbs or eliminates the company’s need to build and operate storerooms for incoming parts and components and to have plant personnel move the inventories to the workstations as needed for assembly.

Illustration Capsule 5.1 describes the path that Amazon.com, Inc. has followed on the way to becoming not only the largest online retailer (as measured by revenues) but also the lowest-cost provider in the industry.

Examples of Companies That Revamped Their Value Chains to Reduce Costs Nucor Corporation, the most profitable steel producer in the United States and one of the largest steel producers worldwide, drastically revamped the value chain process for manufacturing steel products by using relatively inexpensive electric arc furnaces and continuous casting processes. Using electric arc furnaces to melt recycled scrap steel eliminated many of the steps used by traditional steel mills that made their steel products from iron ore, coke, limestone, and other ingredients using costly coke ovens, basic oxygen blast furnaces, ingot casters, and multiple types of finishing facilities—plus Nucor’s value chain system required far fewer employees. As a consequence, Nucor produces steel with a far lower capital investment, a far smaller workforce, and far lower operating costs than traditional steel mills. Nucor’s strategy to replace the traditional steelmaking value chain with its simpler, quicker value chain approach has made it one of the world’s lowest-cost producers of steel, allowing it to take a huge amount of market share away from traditional steel companies and earn attractive profits. (Nucor reported a profit in 188 out of 192 quarters during 1966–2014—a remarkable feat in a mature and cyclical industry notorious for roller-coaster bottom-line performance.)

Southwest Airlines has achieved considerable cost savings by reconfiguring the traditional value chain of commercial airlines, thereby permitting it to offer travelers dramatically lower fares. Its mastery of fast turnarounds at the gates (about 25 minutes versus 45 minutes for rivals) allows its planes to fly more hours per day. This translates into being able to schedule more flights per day with fewer aircraft, allowing Southwest to generate more revenue per plane on average than rivals. Southwest does not offer assigned seating, baggage transfer to connecting airlines, or first-class seating and service, thereby eliminating all the cost-producing activities associated with these features. The company’s fast and user-friendly online reservation system facilitates e-ticketing and reduces staffing requirements at telephone reservation centers and airport counters. Its use of automated check-in equipment reduces staffing requirements for terminal check-in. The company’s carefully designed point-to-point route system minimizes connections, delays, and total trip time for passengers, allowing about 75 percent of Southwest passengers to fly nonstop to their destinations and at the same time reducing Southwest’s costs for flight operations.

Illustration Capsule 5.1

Amazon’s Path to Becoming the Low-Cost Provider in E-commerce

In 1996, shortly after founding Amazon.com, CEO Jeff Bezos told his employees, “When you are small, someone else that is bigger can always come along and take away what you have.” Since then, the company has relentlessly pursued growth, aiming to become the global cost leader in “customer-centric E-commerce” across nearly all consumer merchandise lines. Amazon.com now offers over 230 million items for sale in America—-approximately 30 times more than Walmart—and its annual sales are greater than the next five largest e-retailers combined.

In scaling up, Amazon has achieved lower costs not only through economies of scale, but also by increasing its bargaining power over its supplies and distribution partners. With thousands of suppliers, Amazon.com is not reliant on any one relationship. Suppliers, however, have few other alternative e-retailers that can match Amazon’s reach and popularity. This gives Amazon bargaining power when negotiating revenue sharing and payment schedules. Amazon has even been able to negotiate for space inside suppliers’ warehouses, reducing their own inventory costs.

On the distribution side, Amazon has been developing its own capabilities to reduce reliance on third-party delivery services. Unlike most mega retailers, Amazon’s distribution operation was designed to send small orders to residential customers. Amazon.com attained proximity to its customers by building a substantial network of warehousing facilities and processing capability—249 fulfillment and delivery stations globally. This wide footprint decreases the marginal cost of quick delivery, as well as Amazon’s reliance on cross-country delivery services. In addition, Amazon has adopted innovative delivery services to further lower costs and extend its reach. In India and the UK, for example, through Easy Ship Amazon’s crew picks up orders directly from sellers, eliminating the time and cost of sending goods to a warehouse and the need for more space.

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© Sean Gallup/Getty Images

Amazon’s size has also enabled it to spread the fixed costs of its massive up-front investment in automation across many units. Amazon.com was a pioneer of algorithms generating customized recommendations for customers. While developing these algorithms was resource-intensive, the costs of employing them are low. The more Amazon uses its automated sales tools to drive revenue, the more the up-front development cost is spread thin across total revenue. As a result, the company has lower capital intensity for each dollar of sales than other large retailers (like Walmart and Target). Other proprietary tools that increase the volume and speed of sales—without increasing variable costs—include Amazon.com’s patented One Click Buy feature. All in all, these moves have been helping secure Amazon’s position as the low-cost provider in this industry. Note: Developed with Danielle G. Garver. Sources: Company websites; seekingalpha.com/article/2247493-amazons-competitive-advantage-quantified; Brad Stone, The Everything Store (New York: Back Bay Books, 2013); www.reuters.com/article/us-amazon-com-india-logistics-idUSKCN0T12PL20151112 (accessed February 16, 2016).

Success in achieving a low-cost edge over rivals comes from out-managing rivals in finding ways to perform value chain activities faster, more accurately, and more cost-effectively.

The Keys to Being a Successful Low-Cost Provider While low-cost providers are champions of frugality, they seldom hesitate to spend aggressively on resources and capabilities that promise to drive costs out of the business. Indeed, having competitive assets of this type and ensuring that they remain competitively superior is essential for achieving competitive advantage as a low-cost provider. Walmart, for example, has been an early adopter of state-of-the-art technology throughout its operations; however, the company carefully estimates the cost savings of new technologies before it rushes to invest in them. By continuously investing in complex, cost-saving technologies that are hard for rivals to match, Walmart has sustained its low-cost advantage for over 30 years.

Other companies noted for their successful use of low-cost provider strategies include Vizio in big-screen TVs, EasyJet and Ryanair in airlines, Huawei in networking and telecommunications equipment, Bic in ballpoint pens, Stride Rite in footwear, and Poulan in chain saws.

When a Low-Cost Provider Strategy Works Best A low-cost provider strategy becomes increasingly appealing and competitively powerful when:

1. Price competition among rival sellers is vigorous. Low-cost providers are in the best position to compete offensively on the basis of price, to gain market share at the expense of rivals, to win the business of price-sensitive buyers, to remain profitable despite strong price competition, and to survive price wars.

2. The products of rival sellers are essentially identical and readily available from many eager sellers. Look-alike products and/or overabundant product supply set the stage for lively price competition; in such markets, it is the less efficient, higher- cost companies whose profits get squeezed the most.

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3. It is difficult to achieve product differentiation in ways that have value to buyers. When the differences between product attributes or brands do not matter much to buyers, buyers are nearly always sensitive to price differences, and industry- leading companies tend to be those with the lowest-priced brands.

4. Most buyers use the product in the same ways. With common user requirements, a standardized product can satisfy the needs of buyers, in which case low price, not features or quality, becomes the dominant factor in causing buyers to choose one seller’s product over another’s.

5. Buyers incur low costs in switching their purchases from one seller to another. Low switching costs give buyers the flexibility to shift purchases to lower-priced sellers having equally good products or to attractively priced substitute products. A low-cost leader is well positioned to use low price to induce potential customers to switch to its brand.

A low-cost provider is in the best position to win the business of price-sensitive buyers, set the floor on market price, and still earn a profit.

Pitfalls to Avoid in Pursuing a Low-Cost Provider Strategy Perhaps the biggest mistake a low-cost provider can make is getting carried away with overly aggressive price cutting. Higher unit sales and market shares do not automatically translate into higher profits. Reducing price results in earning a lower profit margin on each unit sold. Thus reducing price improves profitability only if the lower price increases unit sales enough to offset the loss in revenues due to the lower per unit profit margin. A simple numerical example tells the story: Suppose a firm selling 1,000 units at a price of $10, a cost of $9, and a profit margin of $1 opts to cut price 5 percent to $9.50—which reduces the firm’s profit margin to $0.50 per unit sold. If unit costs remain at $9, then it takes a 100 percent sales increase to 2,000 units just to offset the narrower profit margin and get back to total profits of $1,000. Hence, whether a price cut will result in higher or lower profitability depends on how big the resulting sales gains will be and how much, if any, unit costs will fall as sales volumes increase.

Reducing price does not lead to higher total profits unless the added gains in unit sales are large enough to offset the loss in revenues due to lower margins per unit sold.

A second pitfall is relying on cost reduction approaches that can be easily copied by rivals. If rivals find it relatively easy or inexpensive to imitate the leader’s low-cost methods, then the leader’s advantage will be too short-lived to yield a valuable edge in the marketplace.

A low-cost provider’s product offering must always contain enough attributes to be attractive to prospective buyers—low price, by itself, is not always appealing to buyers.

A third pitfall is becoming too fixated on cost reduction. Low costs cannot be pursued so zealously that a firm’s offering ends up being too feature-poor to generate buyer appeal. Furthermore, a company driving hard to push down its costs has to guard against ignoring declining buyer sensitivity to price, increased buyer interest in added features or service, or new developments that alter how buyers use the product. Otherwise, it risks losing market ground if buyers start opting for more upscale or feature- rich products.

Even if these mistakes are avoided, a low-cost provider strategy still entails risk. An innovative rival may discover an even lower-cost value chain approach. Important cost-saving technological breakthroughs may suddenly emerge. And if a low-cost provider has heavy investments in its present means of operating, then it can prove costly to quickly shift to the new value chain approach or a new technology.

BROAD DIFFERENTIATION STRATEGIES

LO 3

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

Differentiation strategies are attractive whenever buyers’ needs and preferences are too diverse to be fully satisfied by a standardized product offering. Successful product differentiation requires careful study to determine what attributes buyers will find appealing, valuable, and worth paying for.3 Then the company must incorporate a combination of these desirable features into its product or service that will be different enough to stand apart from the product or service offerings of rivals. A broad differentiation strategy achieves its aim when a wide range of buyers find the company’s offering more appealing than that of rivals and worth a somewhat higher price.

Successful differentiation allows a firm to do one or more of the following:

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• Command a premium price for its product. • Increase unit sales (because additional buyers are won over by the differentiating features). • Gain buyer loyalty to its brand (because buyers are strongly attracted to the differentiating features and bond with

the company and its products).

CORE CONCEPT The essence of a broad differentiation strategy is to offer unique product attributes that a wide range of buyers find appealing and worth paying more for.

Differentiation enhances profitability whenever a company’s product can command a sufficiently higher price or generate sufficiently bigger unit sales to more than cover the added costs of achieving the differentiation. Company differentiation strategies fail when buyers don’t place much value on the brand’s uniqueness and/or when a company’s differentiating features are easily matched by its rivals.

Companies can pursue differentiation from many angles: a unique taste (Red Bull, Listerine); multiple features (Microsoft Office, Apple Watch); wide selection and one-stop shopping (Home Depot, Alibaba.com); superior service (Ritz-Carlton, Nordstrom); spare parts availability (John Deere; Morgan Motors); engineering design and performance (Mercedes, BMW); high fashion design (Prada, Gucci); product reliability (Whirlpool and Bosch in large home appliances); quality manufacture (Michelin); technological leadership (3M Corporation in bonding and coating products); a full range of services (Charles Schwab in stock brokerage); and wide product selection (Campbell’s soups).

Managing the Value Chain to Create the Differentiating Attributes Differentiation is not something hatched in marketing and advertising departments, nor is it limited to the catchalls of quality and service. Differentiation opportunities can exist in activities all along an industry’s value chain. The most systematic approach that managers can take, however, involves focusing on the value drivers, a set of factors—analogous to cost drivers—that are particularly effective in creating differentiation. Figure 5.3 contains a list of important value drivers. Ways that managers can enhance differentiation based on value drivers include the following:

Figure 5.3 Value Drivers: The Keys to Creating a Differentiation Advantage

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

CORE CONCEPT A value driver is a factor that can have a strong differentiating effect.

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