In a successful strategy the trade-offs between differentiation and low cost are reconciled

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journal article

The Academy of Management Review

Vol. 13, No. 2 (Apr., 1988)

, pp. 202-213 (12 pages)

Published By: Academy of Management

https://doi.org/10.2307/258572

https://www.jstor.org/stable/258572

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Abstract

There is an ongoing debate as to whether the strategies of differentiation and cost leadership are mutually exclusive or whether they can be achieved simultaneously. Using transaction cost theory, a model of business-level strategy is developed that reconciles these divergent perspectives. It is argued that when transaction costs, production costs, and revenue are considered within the calculus of a single model, the trade-offs a firm faces when choosing a business strategy become clearer.

Journal Information

The Academy of Management Review, now in its 26th year, is the most cited of management references. AMR ranks as one of the most influential business journals, publishing academically rigorous, conceptual papers that advance the science and practice of management. AMR is a theory development journal for management and organization scholars around the world. AMR publishes novel, insightful and carefully crafted conceptual articles that challenge conventional wisdom concerning all aspects of organizations and their role in society. The journal is open to a variety of perspectives, including those that seek to improve the effectiveness of, as well as those critical of, management and organizations. Each manuscript published in AMR must provide new theoretical insights that can advance our understanding of management and organizations. Most articles include a review of relevant literature as well. AMR is published four times a year with a circulation of 15,000.

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The Academy of Management (the Academy; AOM) is a leading professional association for scholars dedicated to creating and disseminating knowledge about management and organizations. The Academy's central mission is to enhance the profession of management by advancing the scholarship of management and enriching the professional development of its members. The Academy is also committed to shaping the future of management research and education. Founded in 1936, the Academy of Management is the oldest and largest scholarly management association in the world. Today, the Academy is the professional home for more than 18290 members from 103 nations. Membership in the Academy is open to all individuals who find value in belonging.

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Chapter 6 Business Strategy: Differentiation, Cost Leadership, and Integration Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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6.1 Business-Level Strategy: How to Compete for Advantage BUSINESS-LEVEL STRATEGY

The goal-directed actions managers take in their quest for competitive advantage when competing in a single product market  Who – which customer segments – will we serve?  What customer needs, wishes, and desires will we satisfy?  Why do we want to satisfy them?  How will we satisfy our customers’ needs? 6-3

HOW TO COMPETE FOR ADVANTAGE

DIFFERENTIATION • Create higher value by delivering products/services with unique features

COST LEADERSHIP • Create similar value by delivering products/services at a lower cost and lower prices than competitors

INTEGRATION • Combination of differentiation and cost-leadership strategies

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Exhibit 6.1 Industry and Firm Effects Jointly Determine Competitive Advantage

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Strategic Position  The greater the economic value created (V – C), the greater the firm’s competitive advantage.  A firm’s business-level strategy determines its strategic position.  A business strategy is more likely to lead to a competitive advantage if it allows firms to either perform similar activities differently, or perform different activities than their rivals. 6-6

Generic Business Strategies  Generic strategies (i.e., universal) – independent of industry – can be used by any organization – manufacturing or service, large or small, for-profit or non-profit, public or private, U.S. or non-U.S. – in the quest for competitive advantage.  Value creation and cost tend to be positively correlated. Thus, there exist important trade-offs between value creation and low cost.

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Exhibit 6.2 Strategic Position and Competitive Scope: Generic Business Strategies

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6.2 Differentiation Strategy: Understanding Value Drivers  Product Features • Most important & clearest drivers • Unique product features >> higher price  BMW M3

 Customer Service • ID unmet customer needs & satisfy them  Zappos online retailer  Ritz-Carlton

 Complements • Add value when consumed as a bundle  AT&T U-verse with a DVR add-on 6-9

Strategy Highlight 6.1 Trimming Fat at Whole Foods Market  Whole Foods had lost its competitive advantage due to a failure to control costs effectively.  Trim the fat: • Champion healthy living by offering natural and organic food choices, while also educating consumers • Increase private label by 5% to include over 2,300 products

 A clearly formulated business strategy enables Whole Foods to increase the differentiation value gap and command premium prices, while keeping its cost structure in check. 6-10

6.3 Cost-Leadership Strategy: Understanding Cost Drivers A Cost-Leadership Strategy With Adequate Value

• Managers can manipulate cost drivers to keep their costs low.

Cost Drivers

• Cost of input factors • Economies of scale • Learning-curve effects • Experience-curve effects 6-11

Strategy Highlight 6.2 Ryanair: Lower Cost than the Low-Cost Leader!

 Ryanair has unbundled air travel to its extreme.  More than 20% of Ryanair’s revenues flow from ancillary services: premium-rate phone line to contact them, checked bags, checking in, pillows, blankets, water.  Ryanair offers the basic service (air travel only) for a low price, but charges a steep premium for all other items and upgrades. 6-12

Exhibit 6.5 Economies of Scale, Minimum Efficient Scale, and Diseconomies of Scale

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Economies and Diseconomies of Scale  Economies of Scale – output up, cost per unit down • Spread fixed costs over large output  Microsoft upfront R&D for Windows upgrades

• Specialized systems  ERP software or robots

• Physical properties  Cube-square rule for "big box" stores

 Minimum Efficient Scale (MES) • Lowest cost position constant returns to scale

 Diseconomies of Scale • Complexity of management or physical limits  Gore Associates and aircraft aeronautics 6-14

Cost Drivers: Learning & Experience Curves  Learning Curves • Steeper curve = more learning  Aircraft manufacturing  Cardiac surgeons

 Experience Curves • • • •

Combine economy of scale & learning curves. Scale comes down a given learning curve. Technology allows movement to steeper curve. Combination can leapfrog in competitive advantage.  Walmart high volumes & technology leadership 6-15

Exhibit 6.6

Gaining Competitive Advantage Through Leveraging Learning & Experience Curve Effects

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6.4 Business-Level Strategy and the Five Forces: Benefits and Risks  Cost-Leadership  Benefit: protected from competitors if price war  Risk: new entrant arrives and new capabilities needed

 Differentiation  Benefit: reduced rivalry & high cost of imitation  Risk: might overshoot features needed & vulnerable to pricesensitive customers

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6.5 Integration Strategy: Combining Cost Leadership and Differentiation  Firms skilled in both lowering costs and uniqueness  Difficult because the firm manages internal value chain activities that are fundamentally different from one another  Integration can work if investments are not substitutes but rather complements. • Providing important spill-over effects

 The goal of an integration strategy is a larger economic value (V − C) than that of rivals.

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Exhibit 6.8 Integration Strategy vs. “Stuck in the Middle”

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Exhibit 6.9

Target’s Attempt at Achieving Competitive Advantage by Pursuing an Integration Strategy

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Value and Cost Drivers of Integration Strategy  Quality  Can increase perceived value & lower cost (V − C)

 Economies of Scope  Starbucks adding hot tea to its menu

 Customization  BMW, Threadless.com, Toyota all mass customization

 Innovation  IKEA - stylist furniture in flat pack delivery

 Structure, Culture, & Routines  Ambidextrous organization – Intel

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Exhibit 6.10 Value and Cost Drivers

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6.6 The Dynamics of Competitive Positioning  Strategic Positions Need to Change over Time • PC assemblers need to move to tablets or smartphones

 Productivity Frontier • Value-cost relationship • Captures the best practices at a point in time

 PC Industry  2010 – Apple was a differentiator; HP & Lenovo were “stuck in middle.”  2013 – Lenovo was a differentiator in laptops and desktops, HP still has problems with software transformation, Apple seems to be moving into lower-end products and toward an integration strategy.

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Exhibit 6.11 The Dynamics of Competitive Positioning in the PC Industry: Apple, Lenovo, HP, & Dell

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6.7 Implications for the Strategist  Well-formulated and implemented strategies = Enhanced chances of superior performance  Integration strategies successful only if: • An innovation that reconciles the trade-offs, such as Toyota lean-manufacturing approach in ‘80s & ‘90s

 Goal is to stay on the productivity frontier.

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ChapterCase 6 ©Diego Giudice/Corbis

Consider This… • P&G generally charges a 20–40% premium for its products, reflecting higher value creation, consistent with its differentiation strategy. • Recently, P&G lost market share because of its higher prices, and its profit margins have also been squeezed by the rising costs of input factors. • P&G has slashed its R&D spending in recent years by as much as 50% in an attempt to bring in more innovation from the outside through its Connect+Develop initiative.

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Take-Away Concepts LO 6-1 Define business-level strategy and describe how it determines a firm’s strategic position.

 Business-level strategy determines a firm’s strategic position in its quest for competitive advantage when competing in a single industry or product market.  Strategic positioning requires that managers address strategic trade-offs that arise between value and cost, because higher value tends to go along with higher cost.

 Differentiation and cost leadership are distinct strategic positions.  Besides selecting an appropriate strategic position, managers must also define the scope of competition − whether to pursue a specific market niche or go after the broader market.

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Take-Away Concepts LO 6-2 Examine the relationship between value drivers and differentiation strategy.

 The goal of a differentiation strategy is to increase the perceived value of goods and services so that customers will pay a higher price for additional features.  In a differentiation strategy, the focus of competition is on value-enhancing attributes and features, while controlling costs.  Some of the unique value drivers managers can manipulate are product features, customer service, customization, and complements.  Value drivers contribute to competitive advantage only if their increase in value creation (ΔV) exceeds the increase in costs (ΔC).

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Take-Away Concepts LO 6-3 Examine the relationship between cost drivers and the costleadership strategy.

 The goal of a cost-leadership strategy is to reduce the firm’s cost below that of its competitors.  In a cost-leadership strategy, the focus of competition is achieving the lowest possible cost position, which allows the firm to offer the lowest price while maintaining acceptable value.  Some of the unique cost drivers that managers can manipulate are the cost of input factors, economies of scale, and learning- and experience-curve effects.  No matter how low the price, if there is no acceptable value proposition, the product or service will not sell.

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Take-Away Concepts  The five forces model helps managers LO 6-4 use generic business strategies to Assess the benefits protect themselves against the industry and risks of costforces that drive down profitability. leadership and  Differentiation and cost-leadership differentiation strategies allow firms to carve out business strategies strong strategic positions, not only to vis-à-vis the five protect themselves against the five forces that shape forces, but also to benefit from them in competition. their quest for competitive advantage.  Exhibit 6.7 details the benefits and risks of each business strategy. 6-30

Take-Away Concepts LO 6-5 Evaluate value and cost drivers that may allow a firm to pursue an integration strategy.

 To address the trade-offs between differentiation and cost leadership at the business level, managers may leverage quality, economies of scope, innovation, and the firm’s structure, culture, and routines.  The trade-offs between differentiation and low cost can either be addressed at the business level or at the corporate level.

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Take-Away Concepts LO 6-6 Explain why it is difficult to succeed at an integration strategy.

 A successful integration strategy requires that trade-offs between differentiation and low cost be reconciled.  Integration strategy often is difficult because the two distinct strategic positions require internal value chain activities that are fundamentally different from one another.  When firms fail to resolve strategic trade-offs between differentiation and cost, they end up being “stuck in the middle.” They then succeed at neither strategy, leading to a competitive disadvantage. 6-32

Take-Away Concepts LO 6-7 Describe and evaluate the dynamics of competitive positioning.

 The productivity frontier represents a set of best in-class strategic positions the firm can take relating to value creation and low cost at a given point in time.  Reaching the productivity frontier enhances the likelihood of obtaining a competitive advantage.  Not reaching the productivity frontier implies competitive disadvantage if other firms are positioned at the productivity frontier.  Strategic positions need to change over time as the environment changes. 6-33

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In which of these strategies are the trade

Can companies successfully pursue low costs and differentiation at the same time?

What is low cost & differentiation strategy?

What does Blue Ocean Strategy attempt reconcile?