Two types of overall cost leadership strategy

CHAPTER 5

Business-Level Strategy: Creating and Sustaining Competitive Advantages

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Learning Objectives

After reading this chapter, you should have a good understanding of:

5-1 The central role of competitive advantage in the study of strategic management and the three generic strategies: overall cost leadership, differentiation, and focus.

5-2 How the successful attainment of generic strategies can improve the firm’s relative power vis-à-vis the five forces that determine an industry’s average profitability.

5-3 The pitfalls managers must avoid in striving to attain generic strategies.

5-4 How firms can effectively combine the generic strategies of overall cost leadership and differentiation.

5-5 What factors determine the sustainability of a firm’s competitive advantage.

5-6 The importance of considering the industry life cycle to determine a firm’s business-level strategy and its relative emphasis on functional area strategies and value-creating activities.

5-7 The need for turnaround strategies that enable a firm to reposition its competitive position in an industry.

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The Central Role of Competitive Advantage

Consider . . .

In order to create and sustain a competitive advantage, companies need to stay focused on their customers’ evolving wants and needs and not sacrifice their strategic position as they mature and the market around them evolves.

They also have to have a strategy…

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How firms compete with each other and how they attain and sustain competitive advantages go to the heart of strategic management. In short, the key issue becomes: why do some firms outperform others and enjoy such advantages over time? This subject, business level strategy, is the focus of this chapter.

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Sustaining a Competitive Advantage

Business-level strategies require a choice.

How to overcome the five forces and achieve competitive advantage?

Suggestion – Use Porter’s three generic strategies.

Overall cost leadership

Differentiation

Focus

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Business-level strategy is a strategy designed for a firm or a division of the firm that competes within a single business. Generic strategies = basic types of business level strategies based on breadth of target market (industrywide versus narrow market segment) and type of competitive advantage (low-cost versus uniqueness).

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Three Generic Strategies (1 of 3)

Exhibit 5.1 Three Generic Strategies

Source: Adapted from Competitive Strategy: Techniques for Analyzing Industries and Competitors. Michael E Porter, 1980, 1998, Free Press.

Jump to Appendix 1 for long image description.

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The overall cost leadership and differentiation strategies strive to attain advantages industrywide, while focusers have a narrow target market in mind. Generic strategies are plotted on two dimensions: competitive advantage and market served.

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Three Generic Strategies (2 of 3)

Overall cost leadership is based on:

Creating a low-cost position relative to a firm’s peers

Managing relationships throughout the entire value chain to lower costs

Differentiation implies:

Products and/or services that are unique & valued

Emphasis on nonprice attributes for which customers will gladly pay a premium

A focus strategy requires:

Narrow product lines, buyer segments, or targeted geographic markets

Advantages obtained either through differentiation or cost leadership

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Overall cost leadership = a firm’s generic strategy based on appeal to the industrywide market using a competitive advantage based on low-cost. Differentiation = a firm’s generic strategy based on creating differences in the firm’s product or service offering by creating something that is perceived industrywide as unique and valued by customers. Focus = a firm’s generic strategy based on appeal to a narrow market segment within an industry.

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Three Generic Strategies (3 of 3)

Exhibit 5.2 Competitive Advantage and Business Performance

Particulars Differentiation and Cost Differentiation Cost Differentiation and Focus Cost and Focus Stuck in the Middle
Return on Investment (%) 35.5 32.9 30.2 17.0 23.7 17.8
Sales growth (%) 15.1 13.5 13.5 16.4 17.5 12.2
Gain in market share (%) 5.3 5.3 5.5 6.1 6.3 4.4
Sample Size 123 160 100 141 86 105
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Both casual observation and research supports the notion that firms that identify with one or more of the forms of competitive advantage outperform those that do not. According to the above study, businesses combining multiple forms of competitive advantage (differentiation and overall cost leadership) outperformed businesses that used only a single form. The lowest performers were those that did not identify with any type of advantage. They were classified as “stuck in the middle.”

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Overall Low-Cost Leadership (1 of 2)

Overall cost leadership involves

Aggressive construction of efficient scale facilities

Vigorous pursuit of cost reductions from experience

Tight cost and overhead control

Avoidance of marginal customer accounts

Cost minimization in all activities in the firm’s value chain, such as R&D, service, sales force, and advertising

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Overall cost leadership = a firm’s generic strategy based on appeal to the industrywide market using a competitive advantage based on low-cost. Cost leadership requires a tight set of interrelated tactics, including close scrutiny of the value chain. See Exhibit 5.3.

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Overall Low-Cost Leadership (2 of 2)

Cost leadership requires learning to lower costs through experience: the experience curve.

With experience, unit costs of production processes decline as output increases.

This strategy also requires competitive parity.

Being “on par” with competitors with respect to low-cost, differentiation, or other strategic product characteristics

Permits cost leaders to translate cost advantages directly into higher profits

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Experience curve = the decline in unit costs of production as cumulative output increases. A business can learn to lower costs as it gains experience with production processes. Among the most common factors producing the experience curve are workers getting better at what they do, product designs being simplified as the product matures, and production processes being automated and streamlined. However experience curve gains will only be the foundation for a cost advantage if the firm knows the source of the cost reduction and can keep those gains proprietary. Competitive parity = a firm’s achievement of similarity or being “on par” with competitors with respect to low-cost, differentiation, or other strategic product characteristics. Competitive parity on the basis of differentiation permits the cost leader to translate cost advantages directly into higher profits than competitors. Thus, the cost leader earns above-average returns. A business that strives for a low-cost advantage must attain an absolute cost advantage relative to its rivals. This is typically accomplished by offering a no-frills product or service to a broad target market using standardization to derive the greatest benefits from economies of scale and experience. However such a strategy may fail if the firm is unable to attain parity on important dimensions of differentiation such as quick responses to customer requests for services or design changes.

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Improving Competitive Position vis-à-vis the Five Forces: Cost Leadership

An overall low-cost position

Protects a firm against rivalry from competitors

Protects the firm against powerful buyers

Provides more flexibility to cope with demands from powerful suppliers who want to increase input costs

Provides substantial entry barriers due to economies of scale and cost advantages

Puts the firm in a favorable position with respect to substitute products

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An overall low cost position enables the firm to achieve above average returns despite strong competition. It protects a firm against rivalry from competitors, because lower costs allow a firm to earn returns even if its competitors eroded their profits through intense rivalry. Buyers can exert power to drive down prices only to the level of the next most efficient producer because there are relatively few competitors that can provide a comparable cost/value proposition. Because the cost advantage can be applied across all operations, a low-cost position puts the firm in a favorable position with respect to substitute products introduced by new and existing competitors.

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Pitfalls of Cost Leadership

Too much focus on one or a few value chain activities

Increase in the cost of the inputs on which the advantage is based

Strategy can be too easily imitated

A lack of parity on differentiation

Reduced flexibility

Obsolescence of the basis of a cost advantage

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Firms need to pay attention to all activities in the value chain. Managers should explore all value-chain activities, including relationships among them, as candidates for cost reductions. Firms can also be vulnerable to price increases in the factors of production. A firm’s strategy may consist of value-creating activities that are easy to imitate. Firms striving to attain cost leadership advantages must obtain a level of parity on differentiation. Building a low-cost advantage often requires significant investments in plant and equipment, distribution systems, and large, economically scaled operations. As result, firms often find that these investments limit their flexibility. As a result they have difficulty responding to changes in the environment. Ultimately, the foundation of the firm’s cost advantage may become obsolete. In these circumstances, other firms develop new ways of cutting costs, leaving the old cost-leaders at a significant disadvantage. See Cases: General Motors, & Ford.

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Differentiation (1 of 2)

A differentiation strategy can take many forms:

Prestige or brand image

Quality

Technology

Innovation

Features

Customer service

Dealer network

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Differentiation strategy = a firm’s generic strategy based on creating differences in the firm’s product or service offering by creating something that is perceived industrywide as unique and valued by customers. Firms may differentiate themselves in both primary and support activities (see Exhibit 5.4). Firms achieve and sustain differentiation advantages and attain above-average performance when their price premiums exceed the extra costs incurred in being unique.

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Differentiation (2 of 2)

Differentiation requires:

A level of cost parity relative to competitors

Integration of multiple points along the value chain

Superior material handling operations to minimize damage

Low defect rates to improve quality

Accurate and responsive order processing

Personal relationships with key customers

Rapid response to customer service requests

Differentiation along several different dimensions at once

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Firms achieve and sustain differentiation advantages and attain above-average performance when their price premiums exceed the extra costs incurred in being unique, but a differentiator cannot ignore cost. Differentiators must reduce costs in all areas that do not affect differentiation.

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Improving Competitive Position vis-à-vis the Five Forces: Differentiation

An overall differentiation strategy

Creates higher entry barriers due to customer loyalty

Provides higher margins that enable the firm to deal with supplier power

Reduces buyer power because buyers lack suitable alternatives

Establishes customer loyalty and hence less threat from substitutes

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Differentiation provides protection against rivalry since brand loyalty lowers customer sensitivity to price and raises customer switching costs, therefore creating higher entry barriers and reducing the threat from substitutes. The resulting higher margins and lack of comparable alternatives avoids the need for a low-cost position.

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Pitfalls of Differentiation

Uniqueness that is not valuable

Too much differentiation

Too high a price premium

Differentiation that is easily imitated

Dilution of brand identification through product line extensions

Perceptions of differentiation may vary between buyers and sellers

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It’s not enough just to be different. A differentiation strategy must provide unique bundles of products and/or services that customers value highly. Firms may also strive for quality of service that is higher than customers desire, thus they become vulnerable to competitors who provide an appropriate level of quality at a lower price. In addition customers may desire the product but are repelled by the price premium. Differentiation advantages can be eroded through imitation. Firms may also erode their quality brand image by adding products or services with lower prices and less quality, thus confusing the customer. Companies must also realize that although they may perceive their products and services as differentiated, their customers may view them as commodities.

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Focus (1 of 2)

A focus strategy is based on the choice of a narrow competitive scope within an industry.

A firm selects a segment or group of segments (or niche) and tailors its strategy to serve them.

A firm achieves competitive advantages by dedicating itself to these segments exclusively.

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Focus strategy = a firm’s generic strategy based on appeal to a narrow market segment within an industry. A firm following this strategy selects a segment or group of segments and tailors its strategy to serve them. The essence of focus is the exploitation of a particular market niche.

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Focus (2 of 2)

A focus strategy has two variants.

Cost focus

Creates a cost advantage in its target segment

Exploits differences in cost behavior

Differentiation focus

Differentiates itself in its target market

Exploits the special needs of buyers

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A narrow focus by itself is not sufficient for above average performance. Firms must choose either a cost or a differentiation focus. But both variants of the focus strategy rely on providing better service than broad-based competitors who are trying to serve the focuser’s target segment. Cost focus exploits differences in cost behavior in some segments, while differentiation focus exploits the special needs of buyers in other segments. See Strategy Spotlight 5.3 for the example of a luxury goods provider.

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Improving Competitive Position vis-à-vis the Five Forces: Focus

An overall focus strategy

Creates higher entry barriers due to cost leadership or differentiation or both

Can provide higher margins that enable the firm to deal with supplier power

Reduces buyer power because the firm provides specialized products or services

Focused niches less vulnerable to substitutes

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Focus requires that a firm either have a low cost position with its strategic target, high differentiation, or both. These positions provide defenses against each competitive force because of higher margins or more specialized products or services. Focus is also used to select niches that are least vulnerable to substitutes or where competitors are weakest.

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Pitfalls of Focus

Erosion of cost advantages within the narrow segment

Highly focused products and services still subject to competition from new entrants and from imitation

Focusers too focused to satisfy buyer needs

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The advantages of a cost focus strategy may be fleeting if the cost advantages are eroded over time. University of Phoenix is given as an example. Some firms adopting a focus strategy may enjoy temporary advantages because they select a small niche with few rivals. However, this strategy can be imitated. Finally, some firms attempting to attain advantages through a focus strategy may have too narrow a product or service.

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Combination Strategies: Integrating Low-Cost and Differentiation

Integration of low-cost and differentiation strategies makes it difficult for competitors to duplicate or imitate strategy.

The goal of a combination strategy is to provide unique value in an efficient manner.

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Firms’ integrations of various strategies can provide multiple types of value to customers. A combination low-cost and differentiation strategy enables a firm to provide two types of value to customers: differentiated abilities ( e.g., high quality, brand identification, reputation) and lower prices (because of the firm’s lower costs in value creating activities). For example, superior quality can lead to lower costs because of less need for rework in manufacturing, fewer warranty claims, a reduced need for customer service personnel to resolve customer complaints, and so forth. Combination strategies = firms’ integration of various strategies to provide multiple unique products in small quantities at low cost.

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Combination Strategies

Combining overall low-cost and differentiation strategies can take several forms.

Automated and flexible manufacturing systems allow for mass customization.

Data analytics allows firms to customize product and services while using resources efficiently.

Exploitation of the profit pool concept creates a competitive advantage.

Using information technology, firms can integrate activities throughout the extended value chain.

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Mass customization = a firm’s ability to manufacture unique products in small quantities at low cost. This is facilitated by advances in manufacturing technologies such as CAD/CAM. Andersen Windows is given as an example. Analysis of data on customer characteristics, purchasing patterns, employee productivity and physical asset utilization allows firms to better serve customers while more efficiently using company resources. Profit pool = the total profits in an industry at all points along the industry’s value chain. The structure of the profit pool can be complex. The potential pool of profits will be deeper in some segments of the value chain than others, and the depths will vary within an individual segment. Segment profitability may vary widely by customer group, product category, geographic market, or distribution channel. Additionally, the pattern of profit concentration in an industry is often very different from the pattern of revenue generation. Many firms have also achieved success by integrating activities throughout the extended value chain by using information technology to link their own value change with the value chains of their customers and suppliers.

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Improving Competitive Position vis-à-vis the Five Forces: Combination

An integrated/combination overall low-cost and differentiation strategy

Creates higher entry barriers due to both cost leadership and differentiation

Can provide higher margins that enable the firm to deal with supplier power

Reduces buyer power because of fewer competitors

Overall value proposition reduces threat from substitutes

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Firms that successfully integrate both differentiation and cost advantages create an enviable position. This dominant competitive position serves to erect high entry barriers to potential competitors that have neither the financial nor physical resources to compete head-to-head. The organization’s larger size can provide enormous bargaining power over suppliers. Low pricing and wide selection can reduce the power of buyers because there are relatively few competitors that can provide a comparable cost/value proposition. This overall value proposition also makes potential substitute products a less viable threat. Walmart is given as an example.

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Pitfalls of Combination Strategies

Firms that fail to attain both overall low-cost and differentiation strategies may end up with neither and become “stuck in the middle.”

Firms can also underestimate the challenges and expenses associated with coordinating value-creating activities in the extended value chain.

Firms can also miscalculate sources of revenue and profit pools in the firm’s industry.

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A key issue in strategic management is the creation of competitive advantages that enable the firm to enjoy above average returns. Some firms may become “stuck in the middle” if they try to attain both cost and differentiation advantages. While integrating activities across a firm’s value chain, firms must consider the expenses linked to technology and investment, managerial time and commitment, and the involvement and investment required by the firm’s customers and suppliers. The firm must be confident that it can generate a sufficient scale of operations and revenues to justify all associated expenses. Finally, firms may fail to accurately assess sources of revenue and profits in their value chain.

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Question 1

Which statement regarding competitive advantages is true?

If several competitors pursue similar differentiation tactics, they may all be perceived as equals in the mind of the consumer.

With an overall cost leadership strategy, firms need not be concerned with parity on differentiation.

In the long run, a business with one or more competitive advantages is probably destined to earn normal profits.

Attaining multiple types of competitive advantage is a recipe for failure.

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Answer: A. Recall the discussion of competitive advantage and business performance, Exhibit 5.2, and reflect on whether competitive strategies can be sustained. See the case example in the textbook of Atlas Door, a company that, so far, has been able to sustain a competitive advantage over time.

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Industry Life Cycle Stages (1 of 2)

The industry life cycle

Introduction

Growth

Maturity

Decline

Generic strategies, functional areas, value-creating activities, and overall objectives all vary over the course of an industry life cycle.

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Industry life cycle = the stages of introduction, growth, maturity, and decline that typically occur over the life of an industry. Managers must become even more aware of their firm’s strengths and weaknesses in many areas to attain competitive advantages. Factors such as generic strategies, market growth rate, intensity of competition, and overall objectives can change over the course of an industry life cycle. Managers must strive to emphasize the key functional areas during each of the four stages and to attain a level of parity in all functional areas and value-creating activities. Note: products and services go through many cycles of innovation and renewal. Typically, only fad products have a single lifecycle. Maturity stages of an industry can be transformed or followed by the stage of rapid growth if consumer tastes change, technological innovations take place, or new developments occur.

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Industry Life Cycle Stages (2 of 2)

Exhibit 5.6 Stages of the Industry Life Cycle

Factor Introduction Growth Maturity Decline
Generic strategies Differentiation Differentiation Differentiation Overall cost leadership Overall cost leadership Focus
Market growth rate Low Very large Low to moderate Negative
Number of segments Very few Some Many Few
Intensity of competition Low Increasing Very intense Changing
Emphasis on product design Very high High Low to moderate Low
Emphasis on process design Low Low to moderate High Low
Major functional area(s) of concern Research and development Sales and marketing Production General management and finance
Overall objective Increase market awareness Create consumer demand Defend market share and extend product life cycles Consolidate, maintain, harvest, or exit
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Industry life cycle = the stages of introduction, growth, maturity, and decline that typically occur over the life of an industry.

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Strategies in the Introduction Stage

The introduction stage is when:

Products are unfamiliar to consumers.

Market segments are not well-defined.

Product features are not clearly specified.

Competition tends to be limited.

Strategies:

Develop a product and get users to try it.

Generate exposure so the product becomes “standard.”

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Introduction stage = the first stage of the industry life cycle, characterized by (1) new products that are not known to customers, (2) poorly defined market segments, (3) unspecified product features, (4) low sales growth, (5) rapid technological change, (6) operating losses, and (7) a need for financial support. Since there are few players and not much growth, competition tends to be limited. Success requires an emphasis on research and development and marketing activities to enhance awareness. The challenge becomes one of developing the product and finding a way to get users to try it, and generating enough exposure so the product emerges as the “standard” by which all other rivals’ products are evaluated. There’s an advantage to being the “first mover” in a market.

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Strategies in the Growth Stage

The growth stage is:

Characterized by strong increases in sales

Attractive to potential competitors

When firms can build brand recognition

Strategies:

Create branded differentiated products

Stimulate selective demand

Provide financial resources to support value-chain activities

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Growth stage = the second stage of the product life cycle, characterized by (1) strong increases in sales; (2) growing competition; (3) developing brand recognition; and (4) a need for financing complementary value-chain activities such as marketing, sales, customer service, and research and development. In the growth stage, the primary key to success is to build consumer preferences for specific brands. This requires strong brand recognition, differentiated products, and the financial resources to support a variety of value chain activities such as marketing and sales, and research and development. Efforts in the growth stage are directed towards stimulating selective demand in which a firm’s products offerings are chosen instead of a rival’s. Revenues can increase at an accelerating rate because new consumers are trying the product and a growing proportion of satisfied consumers are making repeat purchases.

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Strategies in the Maturity Stage

The maturity stage is when:

Aggregate industry demand slows

Market becomes saturated, few new adopters

Direct competition becomes predominant

Marginal competitors begin to exit

Strategies:

Create efficient manufacturing operations

Lower costs as customers become price-sensitive

Adopt reverse or breakaway positioning

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Maturity stage = the third stage of the product life cycle, characterized by (1) slowing demand growth, (2) saturated markets, (3) direct competition, (4) price competition, and (5) strategic emphasis on efficient operations. As markets become saturated, there are few new adopters. Rivalry among existing rivals intensifies because of fierce price competition at the same time that expenses associated with attracting new buyers are rising. Advantages based on efficient manufacturing operations and process engineering become more important for keeping costs low as customers become more price sensitive. It also becomes more difficult for firms to differentiate their offerings because users have a greater understanding of products and services. Firms can affect consumers’ mental shifts through (A) reverse positioning = a break in industry tendency to continuously augment products, characteristics of the product life cycle, by offering products with fewer product attributes and lower prices; or (B) breakaway positioning = a break in industry tendency to incrementally improve products along specific dimensions, characteristic of the product life cycle, by offering products that are still in the industry but that are perceived by customers as being different.

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Strategies in the Decline Stage

The decline stage is when:

Industry sales and profits begin to fall.

Price competition increases.

Industry consolidation occurs.

Strategies:

Maintaining the product position

Harvesting profits and reducing costs

Exiting the market

Consolidating or acquiring surviving firms

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Decline stage = the fourth stage of the product life cycle, characterized by (1) falling sales and profits, (2) increasing price competition, and (3) industry consolidation. Firms must face up to the fundamental strategic choices of either exiting or staying and attempting to consolidate their position in the industry. In the decline stage, a firm’s strategic options become dependent on the actions of rivals. If many competitors leave the market, sales and profit opportunities increase. On the other hand, prospects are limited if all competitors remain. Maintaining refers to keeping a product going without significantly reducing marketing support, technological development, or other investments, in the hope that competitors will eventually exit the market. A harvesting strategy = a strategy of bringing as much profit as possible out of the business in the short to medium term by reducing costs. Exiting the market involves dropping the product from the firm’s portfolio. A consolidation strategy = a firm’s acquiring or merging with other firms in an industry in order to enhance market power and gain valuable assets. Firms can also resurrect old technologies by retreating to more defensible ground, using the new to improve the old, or improving the price-performance trade-off.

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Question 2

As markets mature,

costs continue to increase.

applications for patents increase

differentiation opportunities increase.

there is increasing emphasis on efficiency.

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Answer: D. See stages in the maturity cycle.

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Turnaround Strategies

A turnaround strategy involves reversing performance decline and reinvigorating growth toward profitability through

Asset and cost surgery

Selected market and product pruning

Piecemeal productivity improvements

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Turnaround strategy = a strategy that reverses a firm’s decline in performance and returns it to growth and profitability. The need for turnaround may occur at any stage in the life cycle but is more likely to occur during maturity or decline. Most turnarounds require a firm to carefully analyze the external and internal environments. The external analysis leads to identification of market segments and customer groups that may still find the product attractive. Internal analysis results in actions aimed at reduced costs and higher efficiency. See Case Ford, and Case Jamba Juice for how CEOs tried to revamp product lines and put the company on the path to profitability.

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ADA APPENDICES

Description of Images

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Appendix 1: Three Generic Strategies (1 of 4)

Return to slide.

An illustration shows the generic strategies plotted on two dimensions: competitive advantage and market served.

Overall cost leadership leads to low cost position and broad target market.

Cost focus leads to low cost position and narrow target markets.

Broad differentiation leads to superior perceived value by customer and broad target market.

Differentiation focus leads to superior perceived value by customer and narrow target markets.

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