Michael Porter's generic strategies describe how a company can pursue competitive advantage across its chosen market scope. There are three generic strategies: cost leadership, product differentiation, and focus. The focus strategy comprises two variants—cost focus and differentiation focus—allowing the overall framework to be interpreted as four distinct strategic approaches.
A company chooses to pursue one of two types of competitive advantage, either via lower costs than its competition or by differentiating itself along dimensions valued by customers to command a higher price. A company also chooses one of two types of scope, either focus (offering its products to selected segments of the market) or industry-wide, offering its product across many market segments. The generic strategy reflects the choices made regarding both the type of competitive advantage and the scope. The concept was described by Michael Porter in 1980.
Concept Porter wrote in 1980 that strategy targets either cost leadership, differentiation, or focus. These are known as his three generic strategies, which can be applied to any size or form of business. Porter claimed that a company must only choose one of the three or risk that the business would waste precious resources. Porter's generic strategies detail the interaction between cost minimization strategies, product differentiation strategies, and market focus strategies of firms.
Michael Porter described an industry as having multiple segments that can be targeted by a firm. The breadth of its targeting refers to the competitive scope of the business. Porter defined two types of competitive advantage: lower cost or differentiation relative to its rivals. Achieving competitive advantage results from a firm's ability to cope with the five forces better than its rivals. Porter wrote: "Achieving competitive advantage requires a firm to make a choice ... about the type of competitive advantage it seeks to attain and the scope within which it will attain it." He also wrote: "The two basic types of competitive advantage [differentiation and lower cost] combined with the scope of activities for which a firm seeks to achieve them lead to three generic strategies for achieving above average performance in an industry: cost leadership, differentiation and focus. The focus strategy has two variants, cost focus and differentiation focus."
In general: If a firm is targeting customers in most or all segments of an industry based on offering the lowest price, it is following a cost leadership strategy; If it targets customers in most or all segments based on attributes other than price (e.g., via higher product quality or service) to command a higher price, it is pursuing a differentiation strategy. It is attempting to differentiate itself along these dimensions favorably relative to its competition. It seeks to minimize costs in areas that do not differentiate it, to remain cost competitive; or If it is focusing on one or a few segments, it is following a focus strategy. A firm may be attempting to offer a lower cost in that scope (cost focus) or differentiate itself in that scope (differentiation focus). The concept of choice was a different perspective on strategy, as the 1970s paradigm was the pursuit of market share (size and scale) influenced by the experience curve. Companies that pursued the highest market share position to achieve cost advantages fit under Porter's cost leadership generic strategy, but the concept of choice regarding differentiation and focus represented a new perspective.
Porter stressed the idea that only one strategy should be adopted by a firm and failure to do so will result in the "stuck in the middle" scenario shown above.Porter, M.E., "Competitive Strategy: Techniques for analyzing industries and competitors" New York: The Free Press (1980) He discussed the idea that practising more than one strategy will lose the entire focus of the organization: hence clear direction of the future trajectory could not be established. The argument is based on the fundamental that differentiation will incur costs to the firm which clearly contradicts with the basis of low cost strategy and on the other hand relatively standardised products with features acceptable to many customers will not carry any differentiationPanayides, "Unknown" (2003) hence, cost leadership and differentiation strategy will be mutually exclusive. Two focal objectives of low cost leadership and differentiation clash with each other resulting in no proper direction for a firm.
Origin Empirical research on the profit impact of marketing strategy indicated that firms with a high market share were often quite profitable, but so were many firms with low market share. The least profitable firms were those with moderate market share. This was sometimes referred to as the hole in the middle problem. Porter's explanation of this is that firms with high market share were successful because they pursued a cost leadership strategy and firms with low market share were successful because they used market segmentation to focus on a small but profitable market niche. Firms in the middle were less profitable because they did not have a strategy.
Porter suggested that combining multiple strategies is successful in only one case. Combining a market segmentation strategy with a product differentiation strategy was seen as an effective way of matching a firm's product strategy (supply side) to the characteristics of your target market segments (demand side). But combinations like cost leadership with product differentiation were seen as hard (but not impossible) to implement, due to the potential for conflict between cost minimization and the additional cost of value-added differentiation.
Since that time, empirical research has indicated companies pursuing both differentiation and low-cost strategies may be more successful than companies pursuing only one strategy.Wright, Peter, Kroll, Mark, Kedia, Ben, and Pringle, Charles. 1990. Strategic Profiles, Market Share, and Business Performance. Industrial Management, May 1, pp23-28.
Some commentators have made a distinction between cost leadership, that is, low cost strategies, and best cost strategies. They claim that a low cost strategy is rarely able to provide a sustainable competitive advantage. In most cases firms end up in price wars. Instead, they claim a best cost strategy is preferred. This involves providing the best value for a relatively low price.
Cost leadership strategy Cost leadership strategies involve the firm winning market share by appealing to cost-conscious or price-sensitive customers. This is achieved by having the lowest prices in the target market segment, or at least the lowest price to value ratio (price compared to what customers receive). To succeed at offering the lowest price while still achieving profitability and a high return on investment, the firm must be able to operate at a lower cost than its rivals. There are three main ways to achieve this.
The first approach is achieving a high asset utilization. In service industries, this may mean for example a restaurant that turns tables around very quickly, or an airline that turns around flights very fast. In manufacturing, it will involve production of high volumes of output. These approaches mean fixed costs are spread over a larger number of units of the product or service, resulting in a lower unit cost, i.e. the firm hopes to take advantage of economies of scale and experience curve effects. For industrial firms, mass production becomes both a strategy and an end in itself. Higher levels of output both require and result in high market share, and create an entry barrier to potential competitors, who may be unable to achieve the scale necessary to match the firms low costs and prices.
The second dimension is achieving low direct and indirect operating costs. This is achieved by offering high volumes of standardized products, offering basic no-frills products and limiting customization and personalization of service. Production costs are kept low by using fewer components, using standard components, and limiting the number of models produced to ensure larger production runs. Overheads are kept low by paying low wages, locating premises in low rent areas, establishing a cost-conscious culture, etc. Maintaining this strategy requires a continuous search for cost reductions in all aspects of the business. This will include outsourcing, controlling production costs, increasing asset capacity utilization, and minimizing other costs including distribution, R&D and advertising. The associated distribution strategy is to obtain the most extensive distribution possible. Promotional strategy often involves trying to make a virtue out of low cost product features.
The third dimension is control over the value chain encompassing all functional groups (finance, supply/procurement, marketing, inventory, information technology etc.) to ensure low costs. In a supply chain context, this could be achieved by bulk buying to enjoy quantity discounts, squeezing suppliers on price, instituting competitive bidding for contracts, working with vendors to keep inventories low using methods such as Just-in-Time purchasing or Vendor-Managed Inventory. Wal-Mart is famous for squeezing its suppliers to ensure low prices for its goods. Other procurement advantages could come from preferential access to raw materials, or backward integration. For a business which is in control of all functional groups this is suitable for cost leadership; for a business which is only in control of one functional group, this is differentiation. For example, Dell, the computer supplier, initially achieved market share by keeping inventories low and only building computers to order via applying differentiation strategies in supply/procurement chain. This will be clarified in other sections.
Cost leadership strategies are only viable for large firms with the opportunity to enjoy economies of scale and large production volumes and big market share. Small businesses can be "cost focused" not "cost leaders" if they enjoy any advantages conducive to low costs. For example, a local restaurant in a low rent location can attract price-sensitive customers if it offers a limited menu, rapid table turnover and employs staff on minimum wage. Innovation of products or processes may also enable a startup or small company to offer a cheaper product or service where incumbents' costs and prices have become too high. An example is the success of low-cost budget airlines who, despite having fewer planes than the major airlines, were able to achieve market share growth by offering cheap, no-frills services at prices much cheaper than those of the larger incumbents. At the beginning low-cost budget airlines chose "cost focused" strategies but later when the market grew, big airlines started to offer the same low-cost attributes, and so cost focus became cost leadership.
A cost leadership strategy may have the disadvantage of lower customer loyalty, as price-sensitive customers will switch once a lower-priced substitute is available. A reputation as a cost leader may also result in a reputation for low quality, which may make it difficult for a firm to rebrand itself or its products if it chooses to shift to a differentiation strategy in future.
Differentiation strategy Businesses operating this strategy differentiate their products/services in some way in order to compete successfully. Examples of the successful use of a differentiation strategy are Hero, Asian Paints, HUL, Nike athletic shoes (image and brand mark), BMW Group Automobiles, Perstorp BioProducts, Apple Computer (product's design), and Mercedes-Benz automobiles.