The Cost Leadership Strategy

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18th May 2017 Marketing Reference this

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From his literature research, Porter found the complete framework of Porters Five Forces and Generic Strategies. The long development of Five Forces Analysis has brought to the fact that those forces become the determinants of the industry’s competition. These five forces are treat of new entry, rivalry among existing firms, treat from substitute products, bargaining power of buyers, and bargaining power of suppliers. Furthermore, five forces analysis is treated by the organization to measure the level of competition, besides that, it is used as a strong first step in understanding how one industry compares to another and also to determine industry profitability because they influence the prices, costs, and required investment of firm in an industry.

In order to be competitive enough, a normal company that seeks profitability would have to understand how they work in its industry and how they affect the company in its particular situation. Therefore, Three Generic Strategies were implemented to establish a strategic agenda for dealing with these five forces. Porter (1980) proposes that if firms pursue any of his three recommended generic competitive strategies they will be able to outperform competitors who do not pursue such strategies. The recommended strategies are cost leadership, differentiation, and focus strategy.

Cost Leadership Strategy

This type of strategy meant for organizations that has goal to achieve the overall lowest cost structure in an industry. This can be fulfilled through applying efficient business system in an organization. An efficient business system creates cost efficiencies and economic of scales to allow a firm to become the lowest-cost producer. Normally, economists believed that an increase in accumulated experience of a firm in producing or distributing a product or service could decrease the cost of producing or distributing a product or service. However, lowest-cost structure cannot be achieved by cutting the cost alone in one area of business; it demands a reduction in costs on all the departments. Cost leadership not only helps a firm to take down the competitors but also increase market share along with better profit margins.

Furthermore, this strategy is believed to work best in the certain circumstances. Firstly, the cost leadership strategy can be applied when the price competition among rival sellers is especially strong. Secondly, the strategy is suitable for standardized product or readily available from other sellers in the industry. Thirdly, it works best when organization could have few ways to achieve product differentiation, so that buyers get very sensitive to price differences. Unfortunately, this strategy has weakness since it concerns cost reduction rather than quality of the product that leads to decline in the popularity. It is also supported by the fact that nowadays customers are really critical about the quality of the product that makes more customers choose quality rather than cost conscious. In addition, this strategy will become ineffective with an increase in overall cost of a firm’s production inputs. Automatically, an organization will find it hard to hold a cost advantage over a longer time in business environment that keeps changing rapidly.

Differentiation Strategy

Nowadays business environment is really competitive, marketers cannot achieve its goals unless they hold some differential advantage over their rivals. In recent years, much attention has been committed by the marketers to maintain specific competencies; uniqueness could be a strength that makes an organization looks better from its competitors in the eyes of customers. Therefore, uniqueness can be used in gaining a competitive advantage. Obviously, the distinctive competencies also bring incremental value to the market offering when compared to the other offerings to the customers. In consequence, an organization must use different sources of differentiation at different times to build an importance image to its customers. For examples, better features and quality, efficient distribution, research and development, better image of product or service, and also the most important improved customer services. Marketers have realized how customer services could create the business’ image and also build the strong relationships with customers. In the opinion of Thompson and Strickland (1999, cited et Sahaf, 2008) differentiation strategies work best in the some markets circumstances where there are many ways to differentiate the company’s offerings from that of rivals and many buyers perceive these differences as having value. In addition, it is also match with the market where buyer needs and uses of the item or service are diverse, few rival firms are following a similar differentiation approach, and technological chance is fast-paced and competition revolves around evolving product features.

Although differentiation strategy looks perfect but it also gives some challenges to the organization to complete it. Firstly, it is a difficult task to identify the sources of differentiation that are important for the customers and difficult for the competitors to copy. This task is time consuming and not suitable to the business environment that rapidly changes. Secondly, many of people still prefer to buy low-priced products or services over the products that have desirable features since people have mindset why they should purchase the more expensive one if that the products do not give any incremental value for the customers in a firm’s market offering.

Focus Strategy

Focus strategy as suggested by Porter (1985, cited et Sahaf, 2008 ) is based upon the choice of a narrow competitive scope within an industry. By attempting this strategy, it means the organization tries to focus on a particular market segment and to achieve its objective by becoming the market leader in a niche market. The segment may be a group of customers that differentiated by ages and sex. It is believed that an organization can be more efficient and effective by focusing its efforts to a narrow target rather than broad target. Accordingly, this strategy has objective to employ either cost leadership strategy or differentiation strategy to a part of market. A cost focus strategy aims to lowering the prices of the product or service by controlling costs in a narrow target market. For example, a firm is able to be the low cost producer in only one product line. Meanwhile, a differentiation focus strategy means striving to tailor made products to the specific needs of the market segment. Thus such a strategy could utilize some element of differences of firm’s market offering to a narrow market segment. For example, a firm may employ its distinctive competencies to focus on one or a few target markets. Thompson and Strickland (1999 cited Sahaf, 2008 ) added that focus strategy will be useful enough to apply on the following circumstances. Firstly, it works best when it has no other rival is attempting to specialize in the same target segment, added with the fact that is quite hard for multi-segment competitors to meet the specialized needs of the target market niche. This strategy also fits when a firm does not have sufficient resources or capabilities to go after a bigger piece of the total market so focus strategy will work well on this situation when it concerns on one market segment.

Although the focus strategy looks popular among the organization over past decade, there are some risks that need to be considered if a organization commits to this strategy. Firstly, by focusing only to narrow target, the organization doesn’t entitle to enjoy the benefits of the economy of scale that generally occurs in the wide target. Other risks come from the fact that the success of focus strategy over last few years has been attracting many rivals who may think to join the industry that resulting in an increase in the strength of competition.

It is believed that an organization not only needs to have entire knowledge about the events and happenings in the industry but also requires choosing among the above mentioned three generic strategies in order to ensure a better marketing performance. Different strategies suggested by Porter’s generic model call for different organizational systems and capabilities. For example, organizations with adequate resources and good controlling systems may prefer to engage cost leadership and a firm with strong Research and Development facilities may get better results through differentiation strategy. Whereas a small firm with poor resources and inadequate R&D facilities may be better off by serving niche markets, therefore, will be more comfortable with focus strategy.

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Relationship between Porter’s Generic Strategies Analysis and Industry Forces

The three generic strategies suggested by Porter 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. The relationship will be explained below.

1. Competitive Rivalry

Competitive rivalry or also called the competition among existing competitors takes many familiar action such as price discounting, launching new product, advertising campaigns, and service improvements. The competitive rivalry signs that it will limit the profitability of an industry because the cost of competition will tend to increase. Highly competitive rivalry normally occurs when the industry is a mature, growth slowly and the players that take part into the competition also have the same strength or size. The only way that company can expand or increase the market share is by attracting the customers so that customers could be commit and loyal.

In such situation, the benefits of a cost leadership strategy would be that competitiveness in price. For example, Southwest Airlines Company offers low cost air fare to the customers by eliminating some features or services such as no meals on the board, no assigned seats, interline baggage checking, or premium classes of service. Thus, price tells everything that normally people who want to save cost will go for the lower price. Besides that, Southwest’s frequent departures and low fares attract price-sensitive customers who used to travel by bus or car, and convenience-oriented travellers who would choose a full-service airline on other routes. This is a proof that cost leadership strategy can be implemented in this type of industry, and resulting in good benefits to the companies.

However, as competitors pay high attention to price, cost leadership strategy may not be a favourable as all companies would apply the same strategy too and it ends up by reducing their price dramatically. As such situation, differentiation strategy may give better opportunity to the company because it would able to retain loyal customers and they may stay with the company. The reason why it could retain some loyal customers is the task may seems hard to accomplish for competitors to cope with specialised needs of customers who are part of a niche segment in the market. For the example at here is Starbucks, is a well know coffee company that is differentiated by top of the line image and reputation of twin-tailed mermaid. Starbucks spends a lot of time and energy differentiating itself from the competition such as its design of coffee shops, the music played there and the types of products it sells, such as tumbler, coffee-brewing equipment and jazz CDs.

As for focus strategy, companies have the benefits of keeping the differentiation-customers needs so that their rivals are not able to bet them. It can’t be denied that companies who applying such strategy have the possibility to charge a premium price for superior quality or may be offering low price product to a small and special group of buyers. Companies like Chanel, Gucci, Four Seasons Hotels and Resorts make use of successful differentiation-based focused strategies targeted at wealthy buyers wanting high quality of products and services with world-class attributes.

2. Barriers to Entry

Industries that have potential ability to be profitable could attract the outsiders ( companies that don’t involve in the particular industry) because there is chance of entering the industry and taking a part in the profit making. New entrants may create the competition, since it has targeted for the same customers that will lead to higher levels of marketing, sales, and promotional expenses by all competitors as the requirements for differentiation continually increase. If a company employing any one of the three strategies would find it easy to create barriers for new entrants.

The barriers that cost leadership strategy could offer is economies of scale. It may be considered as one of the barriers. In some industries a company’s ability to compete will based on whether it can produce its product or service at a cost that is low enough to offer low competitive price. The experience that company gain for over the years can’t be defeated easily for new entrants to compete on price. For example, economies of scales can be found in practically every activity in the value chain; which ones are most important varies by industry. In microprocessors, incumbents such as Intel are protected by scale economies in research, chip fabrication, and consumer marketing. Intel has been dominating the market for a long time and it really difficult for a new entrant to enter because it will require large capital.

For differentiation strategy, it is an advantage to the company who adopt this strategy because normally those companies have huge amount of loyal customers toward the company’s brand. Thus by knowing this fact, it could discourage the potential entrants to enter the industry. For the instance take the trend of smartphone industry all over the world. This smartphone industry involves three major players that are Blackberry’s Research In Motion (RIM), Google’s Android, and Apple’s Iphone. New entrants do not dare to enter the market because they worry whether they are able to compete with the existing players.

In addition, also companies that employing the focus strategy over time often develop an understanding through research of their customers’ preferences, which is a very difficult task for a potential entrant. By doing this way, focus strategy can act as an entry barrier too.

3. Threat of Substitutes

Substitutes could have two effects on industry competition and profitability. First, the substitutes products establish a maximum price for products and services in the industry; exceeding the maximum would prompt customers to move to the substitute products that are available. Second, substitutes can shape the competition in an industry to rise their marketing and promotional efforts to stem the outflow of customers. Automatically, it gives pressure to the competitors in the industry to keep the prices as low as possible and to spend more much fund to attract and retain customers, which can depress sales and profits in the industry. For the example, downloading mp3 music to the mp3 player compared to buying CDs in music stores.

In order to survive or fight this force, company could apply the cost leadership strategy that aims lower price production against the substitutes. Selling price is one of factors that influence the customer’s decision whether to purchase the product or service or just switch to the substitutes. Take IKEA as an example, IKEA offers the furniture style at low cost to the customers who are happy to do self service rather than employing a salesman. Furthermore, customers are expected to do their own pickup and delivery so that it helps cutting the selling price of the products. By doing so, IKEA can compete with its substitituttes and retain the customer loyalty.

Other than cost leadership strategy, differentiation strategy may also be considered as the method to eliminate or minimize these threats of substitutes. If the companies offer products that are differentiated which have no substitute product, it will minimize the threat. For the example, pharmaceutical companies that offer patented drugs with distinctive medical benefits have more power over health maintenance organizations, hospitals, clinics, and other drug buyers such as drug companies.

Also by applying differentiation-focused strategies, it does effectively reduce the threat of substitutes. Threat of substitutes is reduced in case of the differentiation-focused strategy due to customer loyalty to the unique aspects of a particular product or service. Again we can take IKEA as an example at this strategy; IKEA has differentiated its marketing strategy on how to attract the young customers. IKEA’s marketing concept it’s unique and not offered in other furniture companies. IKEA displays every product it sells in room-like settings, so customers don’t need a decorator to help them imagine how to put the pieces together. And every product has a tag that explains the product materials, size, and price.

4. Buyer Power

In the business world, buyers play the main role in the existence of the organization. As we know, buyers’ action will affect the profitability of the industry’s competitors with their purchase choices. The profitability levels in any industry come from the bargaining power that buyers have in purchasing services and products offered. Buyers may affect profitability by demanding that competitors spend money to deliver other valued dimensions such as improved product quality, extended payment terms, promotional support, and other services. Buyers can be said powerful if they have the ability to negotiate leverage relative to industry players, especially if they are price sensitive, using their influences primarily to pressure price reductions. Nevertheless, the buyers’ power is able to change because it depends with the three generic strategies.

Company might attract the large and powerful buyer if the company adopting cost leaders because it has the distinctive capability to offer lower price options to that kind of buyers. It is a benefit to the company to be a cost leader in the industry, one of the benefits is to get customers’ trust and confidence to the company. Hence, the company can maintain its competitive advantage in the market as other rivals would not able to get strong and powerful buyers.

On the contrary, companies employing the differentiation and focus strategies would have a different scenario. It means that buyers in case of these two strategies would have less power as there are few alternatives available to them. For the example, the buyers of Windows operating system for computer or laptop, produced by Microsoft have much less power due to the fact there are not many other alternatives available to them. Even, there is alternative, it is not common to use since people are comfortable using the Windows operating system. Thus, Microsoft not only maintains it competitive but also controlling the market of this industry that actually created the monopoly market.

5. Supplier Power

Generally, suppliers that are called powerful will keep more of the value for themselves by charging higher prices, restricting quality or services, or shifting costs to industry participants. In addition, powerful suppliers can press profitability out of an industry that is unable to pass on cost increases in its own prices. At this case, again Microsoft could be a good example; it has contributed to the erosion of profitability among personal computer (PC) producers by increasing prices on operating systems. Definitely, the industry of PC is competing extremely for customers who can easily switch among the producers. As a result, PC producers at this situation have limited freedom to increase their prices.

If the supplier has a significant impact on a company’s profitability, then it hold substantial power. For example, there is no substitute for what the supplier group provides, the suppliers would have major power and control in the industry. Pilots’ unions, for example, exercise considerable supplier power over airlines partly because there is no good alternative to a well-trained pilot in the cockpit. Thus, it proves that such companies would have ability to pass the price increases of suppliers to their final customers, through the premium pricing strategy in the scenario of differentiation and focus/niche strategies. What makes differentiation and focus strategy different is the low volume that owned by employing focus strategy even though the firm that applying differentiation-focused strategy is able to pass on supplier price increases easily.

Meanwhile in the case of cost leadership strategy, they are isolated from powerful supplier. It normally occurs in the industry that suppliers have essential customer. Hence, suppliers’ profitability will be closely tied to the industry, and they will want to protect the industry through reasonable pricing and assistance in activities like R&D and lobbying (Porter, 1979).

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