One of the most critical strategic decisions that any business owner needs to make as early as possible is whether to pursue a cost leadership strategy or a differential strategy. Being stuck in the middle is a recipe for disaster.
Professor Michael Porter, the father of competitive strategy, has written an entire text[i] on this topic. You are welcome to purchase the text and keep as a reference. But for the purposes of this article, I have summarised and simplified a key section for all you business owners and marketers.
What is a cost leadership strategy?
A cost leadership strategy is based on a marketing strategy in which price is the main strategic tool and where the business objective is market share leadership.
In order for this strategy to be successful, your business will need to become the lowest-cost producer in its industry. That means managing costs in marketing and non-marketing functions such as production, supply, etc.
Prof. Porter states that a cost leadership strategy is appropriate where a business has a high relative market share and has been able to reduce costs because of economies of scale. He states, 'Cost leadership requires aggressive construction of efficient-scale facilities, vigorous pursuit of cost reductions from experience, tight cost and overhead control, and cost minimisation in areas like service, sales force, advertising and so on.'
What is a differential strategy?
The differential strategy calls for differentiating a product or service from the competitor's products or services. The differentiation may be in the product form, the brand image, features, technology, customer service, pricing or distribution channels.
At the heart of a successful differential strategy is the development of a customer franchise, based on brand loyalty. The differentiator can increase margins and avoid the need to compete in the low cost section of the market. This often implies a lower market share and is a strategy that could be pursued when the low cost leadership position is occupied by a strong competitor.
Stuck in the middle
Prof. Porter warns of the danger of being 'stuck in the middle' where one strategy is not pursued: 'The firm in the middle is almost guaranteed low profitability. It either loses the high-volume customers who demand low prices or must bid away its profits to get this business away from low-cost firms. Yet it also loses high-margin business (the cream) to the firms who are focused on high-margin targets or have achieved differentiation overall. The firm stuck in the middle also probably suffers from a blurred corporate culture and a conflicting set of organisational arrangements and motivation system.'
Strategy options based on relative costs and differential alternatives
Refer to the matrix on the right for analysing the cost leadership versus differential strategy direction for your business and for analysing competitive strategies.
The low relative cost/low degree of differentiation position (box no. 4) is where you would expect to find the market leaders. This is generally a strategy that only the market leader or perhaps a strong number two or three could successfully pursue. The risk for businesses pursuing this strategy is that their cost leadership advantage could diminish over time as the industry matures. To offset this, the business must keep abreast of technological innovation, reinvest in modern equipment, scrap obsolete assets and avoid product line proliferation.
In some rare cases the position shown in box no. 2 may be a strategic alternative. If the business has a low relative cost and a high degree of differentiation, then it can achieve high margins by pricing either at or just above its competitors (who have higher relative costs). This box may also contain businesses in the low-medium relative cost area that price higher than the cost leader but substantiate the premium price by their medium to high level of differentiation. These businesses must have customers that are willing to pay the additional price to receive the 'added value' for the product. The danger of this strategy is that as an industry matures, the products tend to be increasingly regarded by the market to be generics or commodities. The value of paying a premium price for the added value (differential) diminishes and customers turn to the lower priced alternatives.
Where either of these two strategies is not available, the business can choose to focus on a niche or single segment of the market as shown in box no. l. Prestige car manufacturers such as Porsche typically pursue this strategy by producing a relatively high cost product that is highly differentiated. They appeal to a segment that is prepared to pay a high price to acquire a differentiated product.
The final box, to be avoided like the plague, is box no. 3; the high relative cost/low degree of differentiation strategy.
So in conclusion, for your business to be a successful, you must decide on whether to compete on price or on differentiating your products and services. Once that decision has been made, implement the right measures and tactics to support that strategy. Don't get stuck in the middle - avoid that competitive disaster.
© srt marketing 2014