cost-leadership

Cost Leadership And Porter’s Competitive Advantage

Business, Business Models Glossary / By / April 13, 2022

According to Porter, there are three core strategies for competitive positioning: cost leadership, differentiation, and focus.

Cost leadership is straightforward, as the player rolling this out will become the lost-cost producer in the industry.

As Porter highlighted, a cost leader has to have a broad scope (and scale). Indeed, the broad scope is a key element of cost leadership, in the first place.

A cost leader simply will be able to offer among the lowest priced products in the industry, because it achieved cost leadership.

Therefore, the cost-leader isn’t such because it started a price war. Quite the opposite, the cost leader is such, because thanks to its broad industry reach, efficiency, and scale can sell its products at a lower price and yet make margins.

In short, the low-priced product is the effect of cost leadership.

The cost leader has to keep an eye on differentiation as well. Thus, there isn’t a pure cost leader, meant able to be such without differentiation.

A cost leader has to be at least comparable or perceived as such, to enable the cost leader to have enough margins for long-term sustained advantage.

What are the key elements for cost leadership?

While the sources of cost advantage can vary, based on the structural characteristics of the industry, there are some elements that help to build up cost leadership.

  • Economies of scale.
  • Proprietary technology.
  • Preferential access to raw materials.
  • And more.

Cost leadership stems from industry dominance, as more cost leaders in the same industry, according to Porter, can lead to fierce competition and price wars.

Cost leadership vs differentiation vs focused

Cost leadership, differentiation, and focused are three generic strategies first described by Michael Porter in his 1985 book Competitive Advantage: Creating and Sustaining Superior Performance.

porters-generic-strategies
In his book, “Competitive Advantage,” in 1985, Porter conceptualized the concept of competitive advantage, by looking at two key aspects. Industry attractiveness, and the company’s strategic positioning. The latter, according to Porter, can be achieved either via cost leadership, differentiation, or focus.

Porter posited that the relative position of a firm within an industry determined whether its profitability was above or below the industry average. Profit that was consistently above average could result in sustainable competitive advantage, which Porter noted could be attained via low-cost products or differentiation of some kind.

When these sources of competitive advantage are combined with the scope of business activities that support them, three strategies for obtaining above-average performance emerge.

Cost leadership

The cost leadership strategy offers two choices for businesses:

  1. Reduce costs to increase profits whilst selling products at industry-average prices.
  2. Reduce costs to increase market share whilst still making a worthwhile profit.

Note that cost leadership is only concerned with minimizing the cost of delivering a product or service. The price that is paid by the consumer is covered is irrelevant.

Cost leadership is only effective for companies that offer the lowest prices in their industry. Those that sell above these prices are more likely to be undercut by their competitors, which hinders their ability to increase market share.

As a result, cost leadership tends to be associated with various characteristics of market-leading companies, such as:

  • Economies of scale.
  • Access to abundant capital for investment in new technologies.
  • A low-cost base in terms of raw materials, labor, and infrastructure.

Differentiation

This strategy calls on the business to differentiate itself from the competition. Products and services with superior features, durability, support, or functionality are the most obvious form of differentiation, but a company may also stand out in the following ways:

  • High brand equity and recognition among consumers.
  • Industry-wide product distribution that occurs via all major channels.
  • Effective marketing strategies, incorporating such things as ads and sponsorships.

The differentiation strategy can be further divided into three sub-strategies:

  1. Sophistication (higher prices, higher perceived value) – this form is common in the auto industry. Mercedes differentiates itself on status and luxury, while Toyota can charge more because of the reliability of its vehicles and TQM customer satisfaction approach.
  2. Purification (lower prices, lower perceived value) – such as budget airline EasyJet or Indian automotive multinational Tata.
  3. Hybrid (lower prices, higher perceived value) – the best example of hybrid differentiation is IKEA, which can sell affordable furniture thanks to its extremely efficient supply chain management.

Focused

The focused strategy is normally used by small and medium-sized companies. Unable to compete on price or differentiation in the broader market, these companies focus on a particular niche market and take the time to understand the target audience in detail.

They tend to build a smaller but no less devoted following, which makes niche entry unattractive to a larger competitor. It’s important to note that focus on its own is not enough to sustain a competitive advantage. Once a business enters a niche, it must choose either the price or differentiation strategy. 

Southwest Airlines is one example of a company utilizing a focused competitive strategy. Instead of adopting the hub-and-spoke approach of its larger North American counterparts, the company sells short-haul point-to-point flights on less popular routes.

Key takeaways:

  • Cost leadership, product differentiation, and cost focus are three generic strategies first described by Michael Porter in 1985.
  • The cost leadership strategy involves reducing prices to increase profits or market share and is suitable for companies that offer the lowest prices in their industry. The differentiation strategy calls on the business to differentiate itself from the competition via superior products, brand equity, distribution, or marketing nous.
  • The focused strategy tends to be used by small and medium-sized companies that are unable to compete on price or differentiate themselves in larger markets. Instead, they focus on building a loyal following in a particular niche.

Cost leadership examples

Amazon

amazon-vision-statement-mission-statement
Amazon mission statement is to “serve consumers through online and physical stores and focus on selection, price, and convenience.” Amazon vision statement is “to be Earth’s most customer-centric company, where customers can find and discover anything they might want to buy online, and endeavors to offer its customers the lowest possible prices.” 
amazon-case-study
Amazon runs a platform business model as a core model with several business units within. Some units, like Prime and the Advertising business, are highly tied to the e-commerce platform. For instance, Prime helps Amazon reward repeat customers, thus enhancing its platform business. Other units, like AWS, helped improve Amazon’s tech infrastructure.

Aldi

aldi-business-model

Aldi uses a set of strategies to keep its prices low while maintaining a high quality:

  • Aldi lists 1,300 items in each store every day, which is very limited compared to other supermarket chains. That keeps waste to a minimum.
  • Aldi also stocks a lot of their own brands, with some becoming successful, which lowers the sales and marketing cost.
  •  90% of the products are Aldi-exclusive brands, which makes it easy for the chain to market them, with more flexibility on price and distribution.
  • ALDI in a way retains a. self-service attitude, where customers bring their own bags or can buy reusable bags at the store. Also, they must bag their own groceries. This lower the costs of serving clients for the company compared to other chains.
  • Limiting store hours and keeping their stores small (about 15,000-20,000 square feet).

Walmart

walmart-vision-statement-mission-statement
Walmart’smission can be summarized as “helping people around the world save money and live better – anytime and anywhere – in retail stores and through eCommerce.” While its vision is to “make every day easier for busy families.” Walmart defines “busy families” as the bull’s eye of its business strategy.

Other frameworks from Michael Porter

Porter’s Generic Strategies

porters-generic-strategies
In his book, “Competitive Advantage,” in 1985, Porter conceptualized the concept of competitive advantage, by looking at two key aspects. Industry attractiveness, and the company’s strategic positioning. The latter, according to Porter, can be achieved either via cost leadership, differentiation, or focus.

Porter’s Value Chain Model

porters-value-chain-model
In his 1985 book Competitive Advantage, Porter explains that a value chain is a collection of processes that a company performs to create value for its consumers. As a result, he asserts that value chain analysis is directly linked to competitive advantage. Porter’s Value Chain Model is a strategic management tool developed by Harvard Business School professor Michael Porter. The tool analyses a company’s value chain – defined as the combination of processes that the company uses to make money.

Porter’s Diamond Model

porters-diamond-model
Porter’s Diamond Model is a diamond-shaped framework that explains why specific industries in a nation become internationally competitive while those in other nations do not. The model was first published in Michael Porter’s 1990 book The Competitive Advantage of Nations. This framework looks at the firm strategy, structure/rivalry, factor conditions, demand conditions, related and supporting industries.

Porter’s Four Corners Analysis 

four-corners-analysis
Developed by American academic Michael Porter, the Four Corners Analysis helps a business understand its particular competitive landscape. The analysis is a form of competitive intelligence where a business determines its future strategy by assessing its competitors’ strategy, looking at four elements: drivers, current strategy, management assumptions, and capabilities.

Five Forces Model

porter-five-forces
Porter’s Five Forces is a model that helps organizations to gain a better understanding of their industries and competition. Published for the first time by Professor Michael Porter in his book “Competitive Strategy” in the 1980s. The model breaks down industries and markets by analyzing them through five forces

Six Forces Model

six-forces-models
The Six Forces Model is a variation of Porter’s Five Forces. The sixth force, according to this model, is the complementary products. In short, the six forces model is an adaptation especially used in the tech business world to assess the change of the context, based on new market entrants and whether those can play out initially as complementary products and in the long-term substitutes.
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