Three strategies to achieve above-average performance: cost leadership, differentiation, and focus
In order to understand Porter’s Generic Strategies, it is helpful to take a step back and examine the two things which determine a firm’s profitability in the long run.
The first is industry attractiveness, which is determined in any industry by the five competitive forces: the threat of entry by new competitors, the threat of substitutes, the bargaining power of buyers, the bargaining power of suppliers, and the rivalry among existing firms.
Figure 1: Porter’s Five Competitive Forces that Determine Industry Profitability
It is the collective strength of these five forces that determine whether firms in an industry will be able to earn attractive rates of return. In industries where the five forces are favourable, such as the soft drink industry, many competitors have earned attractive returns for many decades. However, where one or more of the forces exerts strong pressure on industry profitability, such as in the airline industry, few firms ever do well for very long.
Understanding industry structure, as determined by the five forces, will inform a firm’s decision to enter or exit an industry, and will also be a key consideration for industry leaders who have the ability to mould industry structure for better or for worse. For example, Coca-Cola is a leader in the soft drink industry and could, if it wanted to, encourage the production and sale of generic unbranded soft drinks. Even if this would increase Coca-Cola’s profits in the short run, it would also threaten the industry structure. Generic cola may increase the price sensitivity of buyers, lead to aggressive price competition, and lower barriers to entry by enabling new competitors to enter the market without a large advertising budget.
In addition to industry attractiveness, the second thing which determines a firm’s profitability in the long run (and this is where Porter’s Generic Strategies comes in) is a firm’s relative position within the industry. That is, can a firm position itself to achieve above average performance within its industry? Or put differently, is it possible for a firm to establish and maintain a competitive advantage?
In his 1985 book Competitive Advantage, Michael Porter explains that there are two basic sources of competitive advantage that a firm can possess: cost leadership and differentiation. A firm can also narrow the scope of its activities to compete in niche segments of the market, and so there are three generic strategies that a firm can adopt to achieve above-average performance: cost leadership, differentiation, and focus.
Figure 2: Three Generic Strategies
Porter’s generic strategies are based on the idea that in order to achieve a competitive advantage a firm needs to make hard choices. Trying to be all things to all people will put a firm on the fast track to mediocrity, and so a firm needs to decide what kind of competitive advantage to pursue and which market segments it should target.
As the name suggests, a firm that pursues cost leadership aims to be the low cost producer in its industry. While the strategy involves a primary focus on cost reduction, the cost leader will still need to produce comparable products in order to maintain prices. If a firm can sustain cost leadership while at the same time charging prices at or near the industry average, then this strategy can allow a firm to achieve above average performance.
One danger of the cost leadership strategy is that if there is more than one aspiring cost leader then this can lead to intense competitive rivalry and ultimately destroy industry profitability. If a firm wants to be the cost leader, then its best bet is to get in first in order to deter the competition.
Differentiation is a strategy in which a firm sets out to provide unique value to buyers. This may be achieved in various ways including producing products with unique features, serving buyers through new or different distribution channels, or by creating perceived differences in the buyer’s mind through clever marketing.
If a firm is able to charge a price premium that exceeds the cost of sustaining its uniqueness, then the firm will be able to achieve above average returns. While the strategy involves a primary focus on “being different” the differentiator still needs to manage costs, and will want to reduce costs in any area that does not contribute to differentiation.
The focus strategy involves narrowing the scope of competition in order to serve certain niche segments within the overall market. By serving these target segments well, the focuser may be able to achieve a competitive advantage in its niche even though it does not enjoy a competitive advantage in the market overall.
Stuck in the Middle
So there you have it, three generic strategies for achieving above average performance: cost leadership, differentiation and focus.
Be warned though, a firm that dabbles in each of these strategies while failing to successfully pursue any of them faces the risk of becoming “stuck in the middle” and being perpetually outperformed by the cost leader, the differentiators and the focusers.
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