During the most recent workshop from the New Entrepreneurs Foundation, we heard from Chris Coleridge. Chris talked about a lot of fascinating things, but one lesson in particular stood out to me – a lesson about choosing your route to success. In summary the lesson was this: When you have a business in an industry with competitors you can either strive to have the lowest costs (this is to be the cost leader) or you differentiate yourself from competitors by offering superior quality or features (making you a differentiator).
In a given market, the cost leader will make money because they have the lowest costs. This means they can either lower their prices to attract more buyers, or they can have average prices and increase their profit margin. The differentiator(s) won’t be able to match low prices, but make up for it by offering higher quality, more choice, additional features, or other additional value.
Why is this distinction important to keep in mind? Because of the huge risks that come with being caught in the middle between those two positions! A business that tries to compete with the differentiator’s product while also having the cost leaders prices will sooner or later run into trouble because they will end up falling short on both fronts. This distinction is known as ‘Porter’s Generic Strategies’ after Michael Porter who first highlighted the risks involved.
So here's an example...
Let’s take the fashion industry in the UK. On the one hand there are companies like Primark which have made a name for themselves as cost leaders – they offer rock bottom prices and you know what you’re getting when you go in. It won’t be the highest quality clothes, and the shops are not particularly pleasant to be in, but there’s nowhere else you’ll get a pair of jeans for £3. At the other end of the scale you have a company like Selfridges that offers extremely high end products and an entirely different (and more pleasant) shopping experience. However, the people who shop at Selfridges don’t mind paying the higher prices because of the added value they get when compared to Primark. Selfridges spend more on making their stores well lit, their products high quality, their customer service top notch and their prices reflect that fact. Both of these companies are profitable because they’ve stuck to their respective strategies.
However, if we consider a company like Debenhams we see a different story. Debenhams tries to position itself in the market as a ‘best for less’ option – the quality of their clothes is important to them, but they also try to highlight their prices as being cheap. The problem is that they aren’t as high quality as the Selfridges of the world, and not as cheap as the Primarks. They do make some money, but it’s not hard to find multiple news stories of their financial problems and they’ve gone bankrupt 3 times in the last 20 years!
Your choice determines your activity
An important consequence of avoiding getting caught in the middle is that your options are limited. If Primark wants to remain profitable, it must continue to pursue the goal of being the cost leader. Perhaps they could decide to open a ‘Primark Premium’ shop which is not quite as cheap as their usual shops, but does offer slightly nicer products. This would be a grave error since they would begin to ‘straddle’ between cost leadership and differentiation. Customers would no longer know Primark as the place to go to buy cheap clothes and their profits would suffer. At the other end, differentiators must continue to spend money on providing the best quality product or service and on marketing that service so that customers understand why their expensive prices are worth it. It can be very tempting for premium brands to decide to offer a more ‘budget’ version of their product.
For instance Apple offer very expensive, high quality electronics and you might think it would be a good idea to sell a ‘Macbook lite’ which maybe isn’t as high quality, but is more affordable. Again, this would be a big error. It is because Apple products are expensive that their brand is as valuable as it is. Selling a cheaper version with lower quality would undermine their core business and they’d soon run in to trouble. Arguably Samsung has made this very mistake with their smartphone business as they try to sell high end, flagship phones like the Samsung Galaxy Note 4 while also offering the cheapest android phones out there, like the Galaxy Fame.
A way out?
There are two ways to avoid having to choose between cost leadership and differentiation: focus, or avoid competition. In this context, the decision to ‘focus’ means that you would focus on a very specific niche market. By offering something of great value to a narrow segment of customers you can avoid having to choose between cost leadership and differentiation. The downside to this approach is that you will lose the ability to grow as much as you might have hoped, since your product is designed to appeal to a niche only.
An example of this approach might be Ferrari which have focussed very much on differentiating themselves so as to appeal to a very specific type of person. They will never sell as many cars as Ford, but they will succeed as a business by remaining focussed in this way. The only other position a business might have is to not have any competitors – meaning you don’t have to worry about being undercut on price and so can’t be undermined by a cost leader. Amazon is an example of this – there’s no one really who can compete with what Amazon and so they are able to market themselves as cheap while also being innovative and different to everyone else out there.
Once you understand the dynamics at work, real world examples will begin to stick out at you. Which companies have fallen in to the ‘straddling’ trap and may be in for a tough ride? Tesco for a long time pursued a cost leader strategy, but has now begun to struggle as cheaper competitors have eaten into Tesco’s market share. Unfortunately for them, they are not perceived by customers as differentiators, offering high quality products or a superior shopping experience. At this point, it’s starting to look like Tesco might be in real trouble – they are a giant that is ripe for disruption.
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