Differentiation relies on the concept that customers will pay more for an item if they perceive that it is different and if the basic for the difference is valued by the customer.
Differentiation involves achieving competitive advantage through pinpointing product or service attributes that customers perceive as valuable and positioning the firm to meet those demands betters than the competition. It refers to -
"...creating something that is perceived industrywide as being unique. Approaches to differentiating can take many forms: design or brand image, technology, (...) features, customer service, dealer network, or other dimensions" (Michael E. Porter ).
Differentiation has several potential advantages:
- Differentiation provides insulation against competitive rivalry because of brand loyalty by customers and resulting lower sensitivity to price.
- It increases margins, which avoids the need for a low-cost position.
- It can provide entry barriers for competitors as a result of customer loyalty and the need for a competitor to overcome the product or service uniqueness.
- Differentiation yields higher margins with which to deal with supplier power.
- It can mitigate buyer power because there are no comparable alternatives.
- The firm that has differentiated itself to achieve customer loyalty should be better positioned vis-a-vis substitutes than its competitors.
Focus is essentially a strategy of segmenting markets. The segment sought may be defined by a particular buyer group, a geographic market segment, or a certain part of the product line. The logic of this approach is that a firm that limits its attention to one or a few market segments can serve those segments better than firms that seek to influence the entire market.
This strategy - "... the low cost and differentiation strategies are aimed at achieving their objectives industrywide, the entire focus strategy is built around serving a particular target very well, and each functional policy is developed with this in mind" (Michael E. Porter ).
The focus strategy has two variants:
- Cost focus
- In cost focus a firm seeks a cost advantage in its target segment. Cost focus exploits differences in cost behavior in some segments.
- Differentiation focus
- In differentiation focus a firm seeks differentiation in its target segment. It exploits the special needs of buyers in certain segments.
Therefore, the firm achieves either differentiation from better meeting the needs of the particular target, or lower costs in serving this target, or both.
Overall differentiation and differentiation focus are the most often confused strategies in practice. The difference is that the overall differentiator bases its strategy on widely valued attributes, while the differentiation focuser looks for segments with special needs and meets them better.
Both variants of the focus strategy rest on differences between a focuser's target segments and other segments in the industry.
If a firm can achieve sustainable cost leadership (cost focus) or differentiation (differentiation focus) in its segment and the segment is structurally attractive, then focuser will be an above-average performer in its industry. How to define segments and choose a sustainable focus strategy is described in section "Industry Segmentation."
Which generic strategy is a chosen is a function of the firm's strengths and weaknesses combined with the competitor's positions in the market.
However, Porter suggests that, whatever strategy is chosen, the firm should try to maintain "parity" with its competitors. Therefore a differentiator should not completely forget price and a low-cost producer should not forget quality.
Porter argued that there is fourth state of affairs in business-level competitive strategy; he labelled it "stuck in the middle" It is not a deliberate strategy per se. Rather, it is the result of not being able to successfully pursue any of the three generic strategies. The result of not having the lowest costs, not being really differentiated in the minds of the consumer, or not successfully targeting a market segment results in a weak profitability and market picture. The firm stuck in the middle is almost always associated with lower profitability and mediocre market share. The firm stuck in the meddle must make a fundamental strategic decision.
To be successful, according to Porter, companies need to select and focus on one of the three proceeding courses of action and the rigorously pursue its application.
"Successfully executing each generic strategy involves resources, strengths, organizational arrangement, and managerial style... Rarely as a firm suited for all three" (Michael E. Porter ).
The implementation of any of the generic strategies entails different skills, resources, and organizational requirements. Some implications for organizations using one of these strategies are summarized in Figure 9-3.
Fundamentally, the risks is pursuing the generic strategies are two:
- first, failing to attain or sustain the strategy;
- second, for the value of the strategic advantage provided by the strategy to erode with industry evolution.
However, the three strategies are predicted on erecting differing kinds of defense against the competitive forces. Therefore, each generic strategy involves different risks which are shown in Table C.
Michael Porter (1985; 1985) proposes a three-stage progression to achieving competitive advantage:
- Analyze the industry structure
- Decide on competitive strategy
- Implement competitive strategy
According to Porter, the starting point of strategy must be the external environment. He believes that external environment defines what the organization needs to achieve and, therefore, what its strategy should be. Each competitive force should be analyzed in depth, through a checklist of factors (see Chapter 5).
Porter's second stage involves the firm deciding on a competitive strategy in order to achieve "sustainable competitors advantage." He suggests there are only two "generic " competitive positions: cost leadership and differentiation. The level of focus can be altered, either concentrating on the whole market or focusing a specific segment (see section above).
The final stage is implementation of the strategy to achieve sustainable competitive advantage. This part of this chapter describes the way a firm can choose and implement a generic strategy and sustain competitive advantages.
The basic tool for diagnosing competitive advantage and finding ways to enhance it is a value chain. Therefore, the first section presents the concept of the value chain. Other sections describe: how a firm can gain a sustainable cost advantage, how a firm can differentiate itself from its competitors, how industries can be segmented, the relationship between technology and competitive advantage.
Porter conceptualized the value chain model as the basic tool for analyzing the sources of competition advantage.
The value chain of a firm is the grouping of primary and secondary activities that make up the product or service provided to the customer (see Figure 9-4).
The firm can be viewed as having a flow of primary activities that directly produce the services or product.
There are five generic categories of primary activities:
- Inbound logistics
- Activities associated with receiving, storing, and disseminating inputs to the product (e.g., material handling, warehousing, inventory control, vehicle scheduling, and returns to suppliers).
- Activities associated with transforming inputs into the final product form (e.g., machining, packing, assembly, printing, and facility operations).
- Outbound logistics
- Activities associated with collecting, storing, and physically distributing the product to buyers (e.g., finished goods warehousing, delivery vehicle operation, order processing, and scheduling).
- Marketing and sales
- Activities associated with providing a means by which buyers can purchase the product and inducing them to do so (such as advertising, promotion, channel selection, channel relations, and pricing).
- Activities associated with providing service to enhance or maintain the value of the product (e.g., installation, repair, training, and product adjustment).
The secondary chain activities support the primary activities. These give the infrastructure for successful product and service provision. They can be divided into four generic categories:
- It refers to the function of purchasing inputs used in the firm's value chain. Some items such as raw materials are purchased by the traditional purchasing department, while other items are purchased by plant managers, office managers or salespersons.
- Technology development
- Technology development consists of a range of activities that can be broadly grouped into efforts to improve the product and the process.
- Human resource management
- It consists of activities involved in the recruiting, hiring, training, development, and compensation of all types of personnel.
- Firm infrastructure
- It consists of a number of activities including general management, planning, finance, accounting, legal, government affairs, and quality management. Firm infrastructure is sometimes viewed as "overhead," but can be a powerful source of competitive advantages.
Linkages are relationships between the way one value activity is performed and the cost or performance of another (e.g., purchasing high-quality, precut steel sheets can simplify manufacturing and reduce scrap). Linkages can lead to competitive advantage in two ways: optimization and coordination.
Linkages among value activities arise from a number of generic causes, among them the following: the same function can be performed in different ways; the cost or performance of direct activities is improved by greater efforts in indirect activities; activities performed inside a firm reduce the need to demonstrate, explain, or service a product in the field; quality assurance functions can be performed in different ways.
The buyer's value chain. Buyers also have value chains, and a firm's product represents a purchased input to the buyers's chain. Understanding the value chains of industrial, commercial, and institutional buyers is easy because of their similarities to that of a firm.
The value chain can be used to compare the firm's current position with the strategy selected in order to assess the strategic gap. The use of activity-based cost measurement with value chain analysis will enable individual components of the business to be evaluated without losing sight of their holistic impact on the competitiveness of the business.
Finally, the basic concept of the value chain has been used by strategists to explain the success of various firms in pursuit of a differentiation or low cost strategy.
Cost advantage is one of two types of competitive advantage a firm may possess. Many strategic plans establish "cost leadership" or "cost reduction" as goals.
This section describes a framework for cost analysis. The framework aims to help a firm understand the behavior of cost in a broad, holistic way that will guide to search for a sustainable cost advantage and contribute to the formulation of contribute strategy.
The value chain provides the basic tool for cost analysis. The starting point for cost analysis is to define a firm's value chain and to assign operating costs and assets to value activities.
The disaggregation of the generic value chain into individual value activities should reflect three principles that are not mutually exclusive:
- the size and growth of the cost represented by the activity
- the cost behavior of the activity
- competitor differences in performing the activity.
Cost advantage results if the firm achieves a lower cumulative cost of performing value activities than its competitors.
A firm's cost position results from the cost behavior of its value activities. Cost behavior depends on a number of structural factors that influence cost, which Porter terms cost drivers.
Ten major cost drivers determine the cost behavior of value activities: economies of a scale, learning, the pattern of capacity utilization, linkages, interrelationships, integration, timing, discretionary policies, location, and institutional factors.
- Economies or diseconomies of scale
- Economies of scale arise from the ability to perform activities differently and more efficiently at larger volume, or from the ability to amortize the cost of intangibles such as advertising and R&D over a greater sales volume. However, increasing complexity and costs of coordination cal lead to diseconomies of scale in a value activity as scale increases. Value activities such as product development, national advertising, and firm infrastructure are typically more scale-sensitive than activities such as procurement and sales force operations. The appropriate measure of scale is a function of how a firm manages an activity.
- Learning and spillovers
- The mechanisms by which learning can lower cost over time are numerous, and include such factors as layout changes, improved scheduling, labor efficiency improvement, product design modifications, procedures that increase the utilization of assets, and better tailoring of raw materials to the process. Learning can spill over from one firm in an industry to another, through mechanisms such as suppliers, consultants, ex-employees, and reverse engineering of products. The appropriate measure of the rate of learning is different for different value activities.
- Pattern of capacity utilization
- Where a value activity has substantial fixed cost associated with it, the cost of an activity will be affected by capacity utilization. Capacity utilization at a given point time is a function of seasonal, cyclical, and other demand or supply fluctuations unrelated to competitive position. The pattern of capacity utilization of an activity is partly determined by environmental conditions and competitor behavior (particularly competitor investment behavior).
- Linkages create the opportunity to lower the total cost of the linked activities. Linkages among value activities pervade the value chain. Vertical linkages are frequently overlooked, because identifying them requires a sophisticated understanding of supplier and channel value chains.
- Interrelationships with other business units within a firm affect cost; particularly when a value activity can be shared with a sister unit.
- The level of vertical integration in a value activity may influence its cost.
- Sometimes a firm may gain first-mover advantages from being among the first to take particular action. Timing can lead to either sustainable cost advantage or a short-term cost advantage.
Discretionary policies independent of other drivers.
The cost of a value activity is always affected by policy choices a firm makes. Some of the policy choices that tend to have the greatest impact on cost include:
- product configuration, performance, and features
- mix and variety of products offered
- level of service provided
- spending rate on marketing and technology development activities
- delivery time
- buyers served (e.g., small versus large)
- channels employed (e.g., fewer, more efficient dealers versus many small ones)
- process technology chosen, independent or scale, timing, or other cost drivers
- the specifications of raw materials or other purchased inputs use (e.g., raw material quality affects processing yield in semiconductors)
- wages paid and amenities provided to employees, relative to prevailing norms
- other human resource policies including hiring, training, and employee motivation
- procedures for scheduling production, maintenance, the sales force and other activities.
- The geographic location of a value activity can affect its cost. However, firms do not always understand the impact of location.
- Institutional factors
- Institutional factors, including government regulation, tax holidays and other financial incentives, unionization, tariffs and levies, and local content rules, constitute the final major cost driver.
- Diagnosing cost drivers.
- The cost behavior of a value activity can be a function of more that one cost driver. A firm must attempt to quantify the relationship between cost drivers and the cost of a value activity whenever possible.
The interactions among drivers take two forms: drivers either reinforce and counteract each other. Drivers frequently reinforce or are related to each other in affecting cost. For example, the effect of location on cost is often related to institutional conditions such as unionization or regulation. Cost drivers can also counteract each other. This means that improving position vis-a-vis one drive may worsen a firm's position vis-a-vis another.
The presence of counteracting cost drivers implies the need for optimization.
Identifying cost drivers and quantifying their effect on cost may not be easy, and number of methods can be employed. Sometimes the cost drivers of a value activity will be intuitively clear from examining its basic economics. Another method of identifying cost drivers is for a firm to examine its own internal experience. Cost drivers can also be determined from interviews with experts. The final method for identifying cost drivers is to compare a firm's cost in a value activity to its competitors' or compare competitors' costs to each other.
Procurement has strategic significance in almost every industry. Every value activity employs purchased inputs of some kind, ranging from raw materials used in purchased fabrication to professional services, office space, and capital goods. Purchased inputs divide into purchased inputs and purchased assets.
The starting point in analyzing the unit cost of purchased inputs is to develop purchasing information. All significant purchased inputs should be identified, and listed in the order of importance to total cost. After sorting purchased by size, regularity of purchase and real cost change, a firm should the identify where it makes the purchasing decision. A final step in developing information about purchased inputs is to record the suppliers for each item and the proportion of purchases awarded to each supplier over an ordering cycle.
The same cost drivers identified above shape the cost behavior of purchased inputs, in combination with the bargaining relationship between the firm and suppliers that grows out of industry structure.
The cost behavior of suppliers will have an important influence on both the cost of inputs and the ability of a firm to exploit supplier linkages. Supplier cost behavior is analyzed in the same way as a firm's cost behavior.
The cost analysis at the segment level must often supplement analysis at the business unit level. Identifying important differences in the value activities for different segments is a starting point in segment cost analysis.
A firm should analyze the costs of those product lines, buyer types, or other portions of its activities that: have significantly different value chains, appear to have different cost drivers, employ questionable procedures for allocating costs.
A firm must consider how the absolute and relative cost of value activities will change over time independent of its strategy. Porter terms this cost dynamics.
The most common sources of cost dynamics include: industry real growth, differential scale sensitivity, different learning rates, differential technological change, relative inflation of costs, aging (older offshore drilling rigs require more maintenance and insurance), market adjustment. Cost dynamics can lead to significant changes in industry structure and relative cost position.
A firm has a cost advantage if its cumulative cost of performing all value activities is lower than competitors' costs. A firm's relative cost position is a function of:
- the composition if its value chain versus competitors'
- its relative position vis-a-vis the cost drives of each activity.
There are two major ways to achieve a cost advantage:
- Control cost drivers. A firm can gain and advantage with respect to the cost drivers of value activities representing a significant proportion of total costs.
- Reconfigure the value chain. A firm can adopt a different and more efficient way to design, produce, distribute, or market the product.
Some generalizations about how controlling each of the ten cost drivers can lead to cost advantage in a activity are as follows:
- Controlling scale.
- Means for accomplishing this include:
- gain the appropriate type of scale
- set policies to reinforce scale economies in scale-sensitive activities
- exploit the types of scale economies where the firm is favored
- emphasize value activities driven by types of scale where the firm has an advantage
- Controlling learning
- Means for accomplishing this include:
- manage with the learning curve
- keep learning proprietary (such as backward integration to protect know-how, controlling employee publications or other forms of information dissemination, retaining key employees, strict non-disclosure provisions in employment contracts)
- learn from competitors
- Controlling the effect of capacity utilization
- Means for accomplishing this include:
- level throughput (such as peak load or contribution pricing, marketing activity, line extensions into less cyclical products, or into products that can intermittently utilize excess capacity, selecting buyers with more stable demand or demands that are counterseasonal or countercyclical, ceding share in high demand periods and regaining it in low demand periods, letting competitors serve fluctuating segments, sharing activities with sister business units with a different pattern of needs)
- reduce the penalty of throughput fluctuations
- Controlling linkages
- These include:
- exploit cost linkages within the value chain
- work with suppliers and channels to exploit vertical linkages
- Controlling interrelationships
- Means for accomplishing this include:
- share appropriate activities
- transfer know-how in managing similar activities
- Controlling integration. Both integration and deintegration offer the potential of lowering costs.
- Controlling timing
- Some of important ways for accomplishing this include:
- exploit first-mover or later-mover advantages
- time purchases in the business cycle
- Controlling discretionary policies
- Means for accomplishing this include:
- modify expensive policies that do not contribute to differentiation
- invest in technology to skew cost drivers in the firm's favor (e.g., developing low-cost processes, facilitating automation, low-cost product designs)
- avoid frills
- Controlling location
- The optimal location of activities changes overtime.
- Controlling institutional factors
- Firms can influence institutional factors such as government policies and unionization.
- Procurement and cost advantage
- A number of possible changes in procurement can reduce costs:
- tune specifications of purchased inputs to meet needs more precisely
- enhance bargaining leverage through purchasing policies
- select appropriate suppliers and manage their cots
- Reconfiguring the Value Chain
- Reconfiguring value chains stem from a number of sources, including: a different production process, differences in automation, direct sales instead of indirect sales, a new raw material, major differences in forward or backward vertical integration, shifting the location of facilities relative to suppliers and customers, new advertising media.
- Reconfiguration downstream
- Reconfiguration of downstream activities can reduce cost substantially.
- Cost advantage through focus
- A focus strategy may also provide a means for achieving a cost advantage that rests on using focus to control cost drivers, reconfiguring the value chain, or both.
Cost advantage will result in above-average performance only if the firm can sustain it. Sustainability varies for different cost drivers and from one industry to another. Timing and integration can also be sources of sustainable cost advantage.
Moreover, sustainability stems not only from the sources of the cost advantage, but also from their number.
Some of the most common errors made by firms in assessing and acting upon cost position include:
- Exclusive focus on the cost of manufacturing activities
- An examination of the entire value chain often results in relatively simple steps that can reduce cost position.
- Ignoring procurement
- Modest changes in purchasing practices could yield major cost benefits for many firms.
- Overlooking indirect or small activities
- Indirect activities, such as maintenance and regulatory costs often escape attention altogether.
- False perception of cost drivers
- Firms often misdiagnose their cost drivers.
- Failure to exploit linkages
- Firms rarely recognize all the linkages that affect cost, particularly linkages with suppliers and linkages among activities such as quality assurance, inspection, and service.
- Contradictory cost reduction
- Cost drivers sometimes work in opposite directions, and a firm must recognize the tradeoffs.
- Unwitting cross subsidy
- Firms often engage in unwitting cross subsidy when they fail to recognize the existence of segments in which cost behave differently.
- Thinking incrementally
- Cost reduction efforts often strive for incremental cost improvements in the existing value chain, rather that finding ways to reconfigure the chain.
- Undermining differentiation
- Cost reduction can undermine differentiation if it eliminates a firm's sources of uniqueness to the buyer.
There are the following steps required in strategic cost analysis:
- Identify the appropriate value chain and assign costs and assets to it.
- Diagnose the costs drivers of each value activity and how they interact.
- Identify competitor value chains, and determine the relative cost of competitors and the sources of cost differences.
- Develop a strategy to lower relative cost position through controlling cost drivers or reconfiguring the value chain and/or downstream value.
- Ensure that cost reduction efforts do not erode differentiation, or make a conscious choice to do so.
- Test the cost reduction strategy for sustainability.
Differentiation involves achieving competitive advantage through pinpointing product or service attributes that customers perceive as valuable and positioning the firm to meet those demands better than the competition.
Virtually any value activity is a potential source of uniqueness. For example, the procurement of raw materials and other inputs can affect of the end product and hence differentiation. Differentiation possibilities can grow out of the firm's value chain. Figure 9-5 illustrates how any activity in the value chain can potentially contribute to differentiation. Other successful differentiators create uniqueness through other primary and support activities Therefore, value chains developed for purpose of strategic cost analysis, may not isolate all activities that are important for differentiation.
A firm's uniqueness in a value activity is determined by a series of basic drivers. Uniqueness drivers are the underlying reasons why an activity is unique.
The principal uniqueness drivers are the following:
- Policy Choices
- Firms make policy choices about what activities to perform them. Some typical policy choices that lead to uniqueness include:
- product features and performance offered
- services provided (e.g., credit, delivery, or repair)
- intensity of an activity adopted (e.g., rate of advertising spending)
- content of activity (e.g., the information provided in order processing)
- technology employed in performing an activity (e.g., precision of machine tools, computerization of order processing)
- quality of inputs procured for an activity
- procedures governing the actions of personnel in an activity (e.g., service procedures, nature of sales calls, frequency of inspection or sampling)
- skill and experience level of personnel employed in an activity, and training provided
- skill and experience level of personnel employed in an activity and training provided
- information employed to control an activity (e.g, number of temperature, pressure, and variables used to control a chemical reaction).
- Uniqueness often stems from linkages within the value chain or with suppliers and channels that a firm exploits. Some typical include:
- Linkages within the value chain. Meeting buyer needs often involves coordinating linked activities.
- Supplier linkages. Uniqueness in meeting buyer needs may also be the result of coordination with suppliers.
- Channel linkages. Some examples of how linkages with channels can lead to unique are as follows: training channels in selling and other business practices; joint selling efforts with channels; subsidizing for channel investments in personnel, facilities, and performance of additional activities.
- Being the first to adopt a product image, for example, may preempt others from doing so and make the firm unique.
- For example, a retail bank may have the most convenient branch and automatic teller machine locations.
- The uniqueness of a value activity may stem from sharing it with sister business units.
- Learning and spillovers
- The uniqueness of an activity can be the result of learning about how to perform it better. The spillover of learning to competitors erodes its contribution to differentiation.
- Integration into new value activities can make a firm unique because the firm is better able to control the performance of the activities. It may also provides more activities to be sources of differentiation.
- Large scale can allow an activity to be performed in a unique way that is not possible at smaller volume.
- Institutional Factors
- Institutional factors sometimes play a role in allowing a firm to be unique.
Attempts to achieve differentiation usually raise costs. The cost of differentiation reflects the cost drivers of the value activities is based. The cost drivers play an important role in determining the success of differentiation strategies and have important competitive implications.
The cost of differentiation reflects the cost drivers of the value activities on which uniqueness is based. The relationship between uniqueness and cost drivers takes two related forms:
- what makes an activity unique (uniqueness drivers) can impact cost drivers
- the cost drivers can affect the cost of being unique.
A successful differentiator finds ways of creating value for buyers that yield a price premium in excess of the extra cost. A firm creates value for a buyer through two mechanisms:
- by lowering buyer cost
- by raising buyer performance
For industrial, commercial, and institutional buyers, differentiation requires that a firm be uniquely able to create competitive advantage for its buyer in ways besides selling to them at a lower price. For households and individual consumers, the cost of a product includes not only financial costs but also time or convenience costs.
A firm lowers buyer cost or raises buyer performance through the impact of its value chain on the buyer's value chain. The links between a firm and its buyer's value chain that are relevant to buyer value depend on how the firm's product is actually used by the buyer. Therefore, differentiation grows out of all the links between a firm and its buyer in which the firm is unique.
A firm can lower its buyer's cost in a number of ways. Table 9-2 lists some of the ways in which a firm's product itself can lower the buyer's direct cost of use.
Buyers seldom pay for value they don't perceive. Thus the price premium a differentiation strategy commands reflects the value actually delivered to the buyer and the value the buyer perceives (even if is not actually delivered). According to this, buyers purchase criteria can be divided into two types:
- Use criteria
- Use criteria might include such factors as product quality, product features, delivery time, and applications engineering support.
- Signaling criteria
- Signaling criteria might include factors such as advertising, the attractiveness of facilities, and reputation. Such signals of value may be as important as actual value (1) when the nature of differentiation is subjective or hard to quantify, (2) when buyers are making a first-time purchase, (3) when repurchase is infrequent, and (4) when buyers are unsophisticated.
Differentiation will lead to superior performance if the value perceived by the buyer exceeds the cost of differentiation. Differentiation strategy aims to create the largest gap between the buyer value created (and hence the resulting price premium) and the cost of uniqueness in a firm's value chain. The final component of differentiation strategy is sustainability.