Porter's generic strategies (HL only)

Professor Michael Porter (b.1947) of Harvard Business School is known throughout the world for his academic work on business strategy. One of his most used tools is Porter's generic strategies, featured in his best-seller "Competitive Advantage" (1985), which outlines the ways that any business - of any size and operating in any industry - can gain a competitive advantage.

If a profitable product or idea can be copied easily, then other firms will simply take advantage by entering the market and taking market share from the existing firm(s) in the industry. Rival businesses might offer an improved product or charge more competitive prices. Hence the original firm in the market loses its competitive advantage.

Porter argued that every successful business must have a competitive advantage to prevent profits being eroded by rival businesses entering the market. A Competitive advantage refers to any factor that enables a business to be more appealing to customers, such as having a unique selling point, or being able to produce goods or services better or cheaply than its rivals. Porter suggested that there are three generic or broad strategies that any business can use to sustain a competitive advantage: (i) cost leadership, (ii) differentiation, and (iii) focus.

1.  Cost leadership

• Cost leadership is a generic strategy that aims to establish a competitive advantage by achieving the lowest operational costs in the market for a particular good or service. It means to become the lowest cost supplier of a product within the market. Examples include providers of low-cost accommodation (such as youth hostels) and budget airlines

• Cost leadership is concerned with minimising costs of production. For example, McDonald’s sells its fast food products at lower prices than premium burger restaurant chains such as Five Guys, Shake Shack, or MAX Burgers. For a cost leadership strategy to succeed, a business needs to be able to reduce its operational costs substantially. McDonald’s large scale operations enables the world's largest fast food brand to achieve huge economies of scale thereby enabling the company to reduce its average or unit costs of production.

Other examples of companies that use a cost leadership strategy include:

• AirAsia - Malaysia's low-cost airline carrier, which is also the largest in Southeast Asia.

• Aldi - Germany’s largest chain of discount supermarkets

• Costco - American multinational wholesaler and retailer

• IKEA - the world's largest furniture retailer

• Adopting a cost leadership strategy means the business can price its products the same as its competitors but earn a higher profit (because the firm's costs are lower). Alternatively, the cost leader can lower its prices below those charged by its rivals in order to attract more customers and therefore gain higher market share.

• Although these firms might charge low prices, they are highly profitable and market leaders in their respective industries. They do not compete with firms that offer higher-quality products since this would require price hikes. The only way to directly compete with these firms is by using penetration or predatory pricing strategies. Alternatively, firms might choose to use technology to cut wastage and to improve productivity, thereby reducing unit costs of production. Hence, cost leaders can enjoy greater profit margins.

• However, to become and remain a cost leader can mean the business has to continually innovate and create new ways to reduce costs. Furthermore, the strategy can be risky as rivals with similar market power can simply try to match the price cuts, which could lead to a price war. Also, cost leaders might develop a reputation for low quality, due to the low prices. This is not necessarily a perception that the business wants to earn. Finally, cost leaders are dependent on a high volume of sales to generate profit, due to the relatively low profit margins.

Methods to achieve cost leadership

• Economies of scale - Operating on a larger scale can enable firms to gain from lower unit costs of production. These cost-saving benefits of being large enable the business to charge lower prices whilst maintaining their profit margins.

• Improved supply chains - Having more efficient methods of distribution also help to reduce costs of production. Some businesses own their suppliers, thereby avoiding the profit margins in the form of higher prices otherwise charged by their suppliers. Some supermarket chains, for example, own their own farms that supply their products. Zara, the Spanish clothes retail giant, also owns many of its suppliers. IKEA, the world's largest furniture retailer, designs and develops all its own products.

• Relocation - A business can be located nearer to its suppliers and/customers in order to reduce transportation and distribution costs.

• Insourcing production - Firms may be able to manufacture goods and/or provide services in-house at a lower cost than an outsourced third-party provider. This may be due to efficiency gains by insourcing and/or due to the profit margin imposed by outsourced providers.

 Top tip!

Remember that cost leadership, as a generic strategy, is about minimizing the cost to the business that is supplying goods or services. This is not the same as the price of the product that is charged to customers.

2.  Differentiation

• A second generic strategy is differentiation. This happens when a firm makes its mass-market products distinct from those of its competitors, e.g., by packaging or branding. Attention is on the quality rather than the cost (and hence the price) of a product. Adidas, Mercedes-Benz, Nike, and Apple all use this strategy to maintain their competitive advantage. Successful differentiation enables a business to charge a premium price. which in turn raises the firm's profit margins.

• Successful differentiation will allow a business to charge a premium price (a price higher than the industry average), thereby earning a higher profit margin. A key drawback of differentiation is that it can be expensive, such as the amount of money needed to successfully develop and promote a high-quality product that stands out from others available on the market. These businesses might choose to use copyrights and patents to protect their competitive advantage.

3.  Focus

• The third generic strategic is called focus. A focus strategy has two variants - businesses gain a competitive advantage by either focusing on being a low cost producer (cost focus), such as discount bric-a-brac stores, or by differentiation within a particular segment (differentiation focus) such as Ferrari, Gucci, Rolex, Dyson, and Chanel.

• Cost focus (a focused cost leadership strategy) requires businesses to compete based on price to target a narrow market (niche market customers). The strategy involves a business charging low prices relative to competitors that operate within the target market. Costs can be kept low by concentrating on a limited number of products or by focusing on a small geographical area.

• Differentiation focus (a focused differentiation strategy) occurs when a business targets a niche or single segment of the market. For example, InThinking focuses on (specializes in) providing dedicated high-quality online resources to support IB Diploma, IGCSE, and MYP teachers and students. Differentiation focus can be a highly profitable strategy due to the high prices that can be charged (and hence the high profit margins) and due to the lack of competition. The drawback is that the market size is rather limited.

 Top tip!

The two focus strategies ("Cost focus" and "Differentiation focus") often cause some confusion as they could be interpreted as meaning "a focus on cost" (a cost leadership strategy) or "a focus on differentiation" (a differentiation strategy). However, remember that focus strategies focus on focused markets.

Instead, remember that:

• Cost focus means a business emphasizes cost-minimization within a focused (narrow or niche) market.

• Differentiation focus means a business pursues strategic differentiation within a focused (narrow or niche) market.

Stuck in the middle

Michael Porter suggests that it is not possible in the long term to adopt a mixture of these three generic strategies. For example, it is not feasible or sustainable to maintain high quality by using a cost leadership strategy, i.e. firms cannot expect to be highly profitable and to have an image of outstanding quality by charging low prices. Porter suggests that firms without a clear business strategy are ‘stuck in the middle’, with detrimental consequences.

Being stuck in the middle means a business is neither a cost leader or a differentiator, and that it is not focused either, i.e. it does not specialise in a narrow (niche) market or a broad (mass) market. This would create confusion for both internal and external stakeholders of the business, Without any competitive advantages and the inability to gain customer loyalty.

Summary of Porter's generic strategies

As a Business Management decision making tool, Michael Porter’s generic strategies help managers and decision makers to concentrate on a specific strategy that best serves their organizations. Porter's generic strategies (sometimes referred to as competitive strategies) can help businesses to gain a competitive edge and increase profitability if executed appropriately. The tool outlines the ways that any business can gain a competitive advantage:

• Cost leadership in mass markets

• Differentiation in mass markets

• Focus - Cost focus or differentiation focus in narrow (focused or niche) markets.

Professor Porter argued that every successful business must have a competitive advantage to prevent profits being eroded by rivals entering the market.

Developed in 1980, and over 40 years later, Porter's generic strategies are still widely applicable to almost any business around the world although perhaps with some slight modifications and new perspectives.