Please read this article for an exploration of the main aspects of Porter’s generic strategies, a critique of their validity and some ideas on how to relate generic strategies to industrial analysis and how to write a good Porter’s generic strategies analysis for a given company. WE will be discussing this in class so it is useful if you have all read this by Monday 4th February 2008
Porter’s Generic Strategies Analysis
Introduction Porter’s generic strategies framework constitutes a major contribution to the development of the strategic management literature. Generic strategies were first presented in two books by Professor Michael Porter of the Harvard Business School (Porter, 1980, 1985). Porter (1980, 1985) suggested that some of the most basic choices faced by companies are essentially the scope of the markets that the company would serve and how the company would compete in the selected markets. Competitive strategies focus on ways in which a company can achieve the most advantageous position that it possibly can in its industry (Pearson, 1999). The profit of a company is essentially the difference between its revenues and costs. Therefore high profitability can be achieved through achieving the lowest costs or the highest prices vis-à-vis the competition. Porter used the terms ‘cost leadership’ and ‘differentiation’, wherein the latter is the way in which companies can earn a price premium.
Main aspects of Porter’s Generic Strategies Analysis Companies can achieve competitive advantages essentially by differentiating their products and services from those of competitors and through low costs. Firms can target their products by a broad target, thereby covering most of the marketplace, or they can focus on a narrow target in the market (Lynch, 2003) (Figure 1). According to Porter, there are three generic strategies that a company can undertake to attain competitive advantage: cost leadership, differentiation, and focus.
Source: Porter (1985)
Porter’s three generic strategies are discussed in more detail in the following section.
Cost leadership The companies that attempt to become the lowest-cost producers in an industry can be referred to as those following a cost leadership strategy. The company with the lowest costs would earn the highest profits in the event when the competing products are essentially undifferentiated, and selling at a standard market price. Companies following this strategy place emphasis on cost reduction in every activity in the value chain. It is important to note that a company might be a cost leader but that does not necessarily imply that the company’s products would have a low price. In certain instances, the company can for instance charge an average price while following the low cost leadership strategy and reinvest the extra profits into the business (Lynch, 2003). Examples of companies following a cost leadership strategy include RyanAir, and easyJet, in airlines, and ASDA and Tesco, in superstores. [Zimbabwean examples include Express Stores, Fashion Discount, Number one stores, and Nick’s Government schools, mission schools and state universities also pursue a cost leadership strategy. Consider how this influences the final product. ] The risk of following the cost leadership strategy is that the company’s focus on reducing costs, even sometimes at the expense of other vital factors, may become so dominant that the company loses vision of why it embarked on one such strategy in the first place.
What other negative consequences can arise from this strategy?
When a company differentiates its products, it is often able to charge a premium price for its products or services in the market. Some general examples of differentiation include better service levels to customers, better product performance etc. in comparison with the existing competitors. Porter (1980) has argued that for a company employing a differentiation strategy, there would be extra costs that the company would have to incur. Such extra costs may include high advertising spending to promote a differentiated brand image for the product, which in fact can be considered as a cost and an investment. McDonalds , for example, is differentiated by its very brand name and brand images of Big Mac and Ronald McDonald. [In Zimbabwe Barbours, Meikles, Greaterman’s, Clicks all have opted for differentiation. The same strategy is also applicable to the private schools ]
Differentiation has many advantages for the firm which makes use of the strategy. Some problematic areas include the difficulty on part of the firm to estimate if the extra costs entailed in differentiation can actually be recovered from the customer through premium pricing. Moreover, successful differentiation strategy of a firm may attract competitors to enter the company’s market segment and copy the differentiated product (Lynch, 2003). This is the major reason why there is such a big pre occupation with intellectual property rights (IPRs) as these confer considerable competitive advantage and permit their owners to leverage earnings from them. Consider the case of software from Microsoft. The end user license agreement for much of the software is annually renewable meaning that the client is forced to buy the same thing over and over. Consider also the rise of the phenomenon of piracy as a consequence of others wanting to cash in on the successful brand “microsoft”
Porter initially presented focus as one of the three generic strategies, but later identified focus as a moderator of the two strategies. Companies employ this strategy by focusing on the areas in a market where there is the least amount of competition (Pearson, 1999). Organisations can make use of the focus strategy by focusing on a specific niche in the market and offering specialised products for that niche. This is why the focus strategy is also sometimes referred to as the niche strategy (Lynch, 2003). Therefore, competitive advantage can be achieved only in the company’s target segments by employing the focus strategy. The company can make use of the cost leadership or differentiation approach with regard to the focus strategy. In that, a company using the cost focus approach would aim for a cost advantage in its target segment only. If a company is using the differentiation focus approach, it would aim for differentiation in its target segment only, and not the overall market.
This strategy provides the company the possibility to charge a premium price for superior quality (differentiation focus) or by offering a low price product to a small and specialised group of buyers (cost focus). Ferrari and Rolls-Royce are classic examples of niche players in the automobile industry. Both these companies have a niche of premium products available at a premium price. Moreover, they have a small percentage of the worldwide market, which is a trait characteristic of niche players. The downside of the focus strategy, however, is that the niche characteristically is small and may not be significant or large enough to justify a company’s attention. The focus on costs can be difficult in industries where economies of scale play an important role. There is the evident danger that the niche may disappear over time, as the business environment and customer preferences change over time.
Stuck in the middle According to Porter (1980), a company’s failure to make a choice between cost leadership and differentiation essentially implies that the company is stuck in the middle. There is no competitive advantage for a company that is stuck in the middle and the result is often poor financial performance (Porter, 1980). However, there is disagreement between scholars on this aspect of the analysis. Kay (1993) and Miller (1992) have cited empirical examples of successful companies like Toyota and Benetton, which have adopted more than one generic strategy. Both these companies used the generic strategies of differentiation and low cost simultaneously, which led to the success of the companies.
How to write a Good Porter’s Generic Strategies Analysis
Firms can choose from one of the three generic strategies to compete in the marketplace, regardless of the context of industry (Porter, 1980). Note that companies that are successful at making use of the cost leadership strategy are often positioned to capitalize on a value proposition which emerges from their low cost emphasis, like the classic success story of Tesco , in the UK. These companies typically focus their efforts on value-oriented customers in the market. Tesco , Value products are focused on providing value-oriented customers with products that are indeed value-for-money, relative to competitive offerings. Interestingly, an emphasis on cost leadership in this sense can act as a form of differentiation. Successful implementation of a cost leadership strategy would benefit from process engineering skills, products designed for ease of manufacture, access to inexpensive capital, tight cost control and incentives based largely on quantitative targets (www.wikipedia.org). McDonalds, restaurants, for example, achieve low costs through standardised products, and centralised buying of supplies etc. Despite the benefits that the cost leadership strategy entails, there is limited empirical evidence that supports successful implementation of cost leadership strategies.
Contrary to the cost leadership strategy, there is empirical evidence to support the differentiation strategy (Pearson, 1999). Hall (1980) investigated sixty-four American companies and the findings of the study revealed that companies following a differentiation strategy had superior performance compared to those companies that were not following the same. It is important for analysts to note that there is more than one way in which a company can make use of differentiation. Differentiation can be achieved through a differentiated product, superior quality, and customer service etc. A key question to ask is whether the customers of the company perceive the point of difference as one that is worth a price premium.
The focal point for the company pursuing a differentiation strategy should be the customer, and not per se the competitors. Note that for a differentiation strategy to be successful, the point of differentiation perceived by customers as valuable should coincide with the distinctive competence of the company (Pearson, 1999). For example, Orange succeeded by providing the most basic requirements for mobile phone communication, better than the competition, and in that the company created a differentiation in the minds of the consumers. Orange provided the customers with mobile phone communication requirements like better network coverage, network reliability, and charging customers for only what they use, instead of features like free phone calls, which even have a higher cost for provider (Barwise et al, 2004). Therefore, a customer-focused differentiation strategy when implemented with a clear vision benefits the company in many ways including price premium, brand loyalty and sometimes even reduced costs, like the case of Orange. In order to effectively maintain a differentiation strategy, the firm should have strong skills in R&D, product engineering, change management, marketing, advertising, and HRM. Continuous innovation plays a vital role in case of differentiation, as is exemplified by companies like IBM, also referred to as the IT bluehood of the corporate world. IBM was awarded more US patents in 2003 than any other company, for the eleventh year running, which qualifies IBM as one of the most innovative and successful companies in its industry.
Notably, a number of small and medium sized companies have found that the niche strategy is the most useful strategic area to explore for them (Lynch, 2003). While most companies employ cost leadership strategy, differentiation, or a mix of these two strategies, there are relatively fewer companies that adopt a niche strategy. Perhaps one of the most important elements to consider in case of a niche strategy is whether the size of the market is appropriate from the revenue potential aspect, and if the company has the capability to provide the specialised products that the consumers in the niche market need and want.
According to Parnell (2006), the stuck in the middle phenomenon received considerable support in the 1980s (Dess et al, 1984; Hawes et al 1984) but was later challenged by numerous scholars (Buzzell and Gale, 1987; Proff, 2000). It has been noted that a shortcoming of the low-cost-differentiation dichotomy, is that the two strategies are not opposites in entirety, and are neither always mutually exclusive (Parnell, 1997). Notably, most successful firms exhibit one or more forms of differentiation, along with forms that are directly associated with cost leadership and even the focus orientation. This is one of the trickiest areas in the analysis of generic strategies that the reality can be different and more subtle than the stark contrasts that are highlighted by Porter (1980). It is important to conduct the analysis with an open mind, and to explore the relative advantages, disadvantages, and risks that the various strategies may offer to a company vis-à-vis the competition and overall business environment.
Information Technology and the advent of the Internet have caused major changes in the business environment and have accelerated the speed of change. Kim et al (2004) have argued that Porter’s generic strategies of differentiation and cost leadership will be applicable to e-business firms in a broad sense, while the focus/niche strategy will not be as viable for e-business firms, compared to their traditional counterparts. They suggest that an integration of cost leadership and differentiation strategies would be the most promising in the e-business context, but individually differentiation will show superior performance compared to cost leadership. As more and more companies are transforming their bricks-and-mortar existences to brick-and-click, it is vital for analysts to understand the role that generic strategies are playing in the digital era.
Where to find information for Porter’s Generic Strategies Analysis Analysts can explore various sources to find information necessary for conducting the generic strategies analysis. Possible sources of information include company and competitor websites in order to view the existing portfolio of products or services that are being offered to customers. The annual reports of the company can used to analyse the relationships between costs and profitability, and how a particular strategy is affecting the firm’s overall performance.
Marketing communications tools used by the company and competitors may also reflect the generic strategies. Advertisements can be a useful source of information to analyse the strategy that is being pursued by the company, and how that differs from that of the competition. Journal articles, trade publications and reputable magazine articles are useful sources of information to analyse industry trends, customer preferences in a given market, and the strategies that are being pursued by the companies in a particular industry.
Relationship between Porter’s Generic Strategies Analysis & Industry Forces The three generic strategies suggested by Porter (1980, 1985) can be effectively utilised to defend against competitive forces in the business environment. The industry forces take the form of competitive rivalry, barriers to entry, threat of substitutes, buyer power, and supplier power (Lynch, 2003).
If the competition in the industry in which the company operates is fierce, the advantage of a cost leadership strategy would be that the firm would be able to compete on price. However, cost leadership strategy is not the most desirable strategy in this event, as competitors may put intense price pressures, such that all companies would end up reducing their prices drastically. Differentiation would be a viable strategy in this case as there is a likelihood that the loyal customers would stay with the company. It would also be hard for competitors to cope with the specialised needs of customers who are part of a niche segment in the market.
Barriers to Entry A company employing any one of the three strategies would find it easy to create barriers for new entrants. The learning curve of cost leaders in an industry, along with the economies of scale through experience curve effects, would often make it impossible for potential entrants to compete on price, as the more mature firm can further lower prices without comprising its profitability. High customer loyalty towards a company’s brands, which is true for the differentiation strategy, can play a vital role in discouraging potential entrants. Customers often choose to be with a niche player because of a certain core competence that only that particular player is providing in the market. Also companies that make use of the focus strategy over time often develop a thorough understanding of their customers’ needs, which is a very difficult task for a potential entrant. In this way, focus can act as an entry barrier also.
Threat of substitutes It is the differentiation and differentiation-focused strategies that effectively reduce the threat of substitutes. Threat of substitutes is reduced in case of the differentiation strategy due to customer loyalty to the unique aspects of a particular product or service, which no substitute product can offer in the customer’s mind. In case of the later strategy, the very nature of the company’s products and core competence of the firm reduce the threat of substitutes.
Buyer Power The power of buyers changes in accordance with the three generic strategies. Cost leaders have the unique ability to offer lower price options to large and powerful buyers. However, the scenario differs for companies making use of the differentiation and focus strategies. Buyers in case of these two strategies would have less power as there are few alternatives available to them.
Suppliers can exercise their power primarily in case of differentiation and focus/niche strategies. Companies making use of these strategies have the ability to pass the price increases of suppliers to their final customers, through the premium pricing strategy.
Limitations of Porter’s Generic Strategies Analysis During the 1980s, the generic strategies were regarded as fundamental to strategy and the ideas suggested by Porter were used extensively. It became clear over time that in reality there were some shades of grey in the distinction between differentiation and cost, compared to the black and white that is projected in theory. It is very difficult for most companies to completely ignore cost, no matter how different their product offering is. Similarly, most companies will not admit that their product is essentially the same as that of others (Macmillan et al, 2000).
It is important for analysts to bear in mind that Porter’s generic strategies should be considered as a part of a broader strategic analysis. The generic strategies only provide a good starting point for exploring the concepts of cost leadership and differentiation. Perhaps a major limitation of the generic strategies is that they may not provide relevant strategic routes in the case of fast growing markets (Lynch, 2003). It is important to conduct other analyses like PESTEL analysis to analyse how the generic strategy being employed by a company should change in accordance with external factors. Other useful analyses would include SWOTanalysis, analysis of the key success factors etc.
Porter’s generic strategies framework suggests that a company can maximize performance by striving to be the cost leader in an industry, by differentiating its products or services from those of other companies, and by focusing on a narrow target in the market. A company that attempts to combine cost leadership and differentiation strategies would invariably be stuck in the middle, which according to Porter is not a desirable notion. It is seen that each of the generic strategies has advantages and inherent risks that should be analysed carefully with respect to the company and its competitors. It is noted that in practice, most successful companies make use of a combination of low cost and differentiation strategies, which is true even in the context of online business.
It is seen that Porter’s generic strategies can be effective in defending against competitive forces in the industry. Key sources of information for conducting a generic strategies analysis include company and competitor websites, annual reports, advertising, and journal articles, trade publications and reputable magazine articles. Porter’s generic strategies have certain limitations which include shades of grey in the distinction between differentiation and cost, compared to the black and white approach suggested by Porter. Also, analysts must use the generic strategies analysis as only a part of a broader strategic analysis. Use of other strategic models and tools like PESTEL, SWOT etc. is recommended for a more holistic analysis.
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