Competitive strategy: cost leadership, differentiation and focus

How do you judge a company’s strategy?

A company’s competitive strategy is a key part of its business model (the customers it serves, what it sells them, the resources it relies on and its partners; Corporate Finance covers the business model). Every company has one, intentional or not.

An intentional strategy shapes the business model: it sets measurable goals, shares them with staff and investors, tracks results against them and uses what it learns to refine the next plan. An unintentional strategy is what results when managers chase their own incentives, keep doing what they did before or imitate the industry leader. That is the difference between intentional and unintentional strategy .

Good strategies tend to create value for investors, but whether one has is hard to tell until years have passed: a share price shows only what investors believe today. So the analyst judges the strategy looking forward, with three tests of a competitive strategy : the Five Forces, the PESTLE (political, economic, social, technological, legal and environmental) influences, and the company’s own resources.

Is the strategy sound?forward-looking: value creation is clear only after time has passed

• 1. Defense against the Five Forces Memorize does it blunt entrants, substitutes, customers, suppliers and industry rivalry?
• 2. Fit with PESTLE influences Memorize does it benefit from, or at least not fight, outside trends?
• 3. Resources and capabilities Memorize can the company actually carry it out?

1. Defense against the Five Forces. Does the strategy blunt the threat of entrants and substitutes and the power of customers, suppliers and rivals?
2. Fit with the PESTLE influences. Does the strategy benefit from, or at least not fight, the expected outside trends? A strategy built on cheap carbon-heavy energy fights a rising carbon price.
3. Resources and capabilities. Can the company actually do it? A good idea in the wrong hands earns nothing.

How long a firm keeps creating value also depends on where the company and its industry are in their development, how it responds to its rivals and the outside influences on it. Lesson 2 follows a company through its life cycle; this lesson covers the strategies of established firms.

What strategies do established firms use?

Michael Porter, who also devised the Five Forces, described three strategies that established firms with a track record use in many variations: cost leadership, differentiation and focus. A firm with no cost lead, no difference customers will pay for and no niche is stuck in the middle , a weak position with no clear advantage.

Generic strategiesnone of the three: stuck in the middle

• Cost leadership Memorize lowest-cost provider in the industry
  • How scale, scope, supply chain, cost control, aggressive pricing, low-cost distribution
  • Defends against Memorize entrants, customers, industry rivalry
  • Suits capital-intensive, price-conscious, little difference or innovation
  • Risks cost inflation, technology, premiumization
• Differentiation Memorize a product customers pay more for
  • How quality, brand, service, intellectual property, experience, premium price, bundling
  • Defends against Memorize entrants, substitutes, customers, industry rivalry
  • Suits customers value uniqueness; changing features
  • Risks imitation, sophisticated buyers, excessive premium, capped share
• Focus Memorize one group, region or product
  • Cost-based focus Memorize lowest price in a narrow segment
  • Differentiation-based focus Memorize unique product, premium price, niche
  • Defends against Memorize entrants, substitutes, customers
  • Risks large rivals undercut, groups converge, sophisticated buyers

Cost leadership means becoming the lowest-cost provider among all competitors in an industry. It is most common where products are commoditized or barely differ, the industry is mature with little innovation, and customers care mostly about price, as in commodity processing and refining or consumer staples. It takes several forms:

• Economies of scale : producing more lowers the average cost per unit.
• Economies of scope : supplying several products together lowers the average cost of each, for example by running them through the same plants, warehouses and trucks.
• Access to materials and the supply chain, low-cost distribution, and buying smaller rivals to push their products through the leader’s own network.
• Cost control, and for firms with high fixed costs, keeping capacity full (capacity utilization ).
• Aggressive pricing to win volume.

Cost leadership defends against new entrants (they need the same scale), customer bargaining power (customers can push the price only down to the next producer’s cost) and industry rivalry (higher-cost rivals cannot match its price for long).

How do you see capacity utilization in the numbers?

Use it

Airlines have high fixed costs, so filling seats is the heart of a low-cost strategy. Available seat kilometers (ASK) are the seats offered times the kilometers flown; revenue passenger kilometers (RPK) are the kilometers flown by paying passengers. Their ratio, the load factor , is the airline industry’s measure of capacity utilization. Cost per available seat kilometer (CASK) compares cost levels across airlines of different sizes.

$$\text{Load factor} = \dfrac{\text{revenue passenger kilometers (RPK)}}{\text{available seat kilometers (ASK)}}$$

Tying past results to the strategy like this gives the analyst a base for forecasts.

Differentiation can rest on quality or features, a brand built by advertising, service and distribution, intellectual property (IP), the customer experience, premium pricing, or bundling the product with other services. How long it protects market share and profits depends on how easily rivals can copy it: patents and copyrights are legal barriers that last, while most other differences fade quickly. A subscription model deepens differentiation: the company watches what each customer does, tailors offers and earns a steady, predictable revenue stream.

Differentiation defends against new entrants and substitutes (loyalty deters switching), customer bargaining power (customers compare less on price) and industry rivalry (a distinct product takes the firm out of head-to-head price competition). It suits industries where customers are less price-conscious, value uniqueness and see product features change through innovation.

Focus usually combines elements of cost leadership and differentiation and applies them to one area: a region, a narrower range of products or one customer group. It works where broader competitors find those customers, regions or products hard to serve. It comes in two kinds:

• Differentiation-based focus : a unique product for a niche, sold at a premium price. Lumen Ledger, which sells accounting software only to firms with fewer than 50 staff and ties it to their accountants, is an example.
• Cost-based focus : the lowest price within one narrow segment. Brightwash, a car-wash chain that offers only a basic wash at the lowest price in its city, is an example.

Focus defends against new entrants, substitutes and customer bargaining power, inside its niche.

	Cost leadership	Differentiation	Focus
Forms	economies of scale and scope, access to materials and supply chain, cost control, aggressive pricing, low-cost distribution	quality and features, advertising and brand, service and distribution, intellectual property, customer experience, premium pricing, bundling	elements of both, aimed at one group or product (cost-based or differentiation-based)
Defends against	new entrants, customer bargaining power, industry rivalry	new entrants, substitutes, customer bargaining power, industry rivalry	new entrants, substitutes, customer bargaining power
Suits	capital-intensive industries, price-conscious customers, little product difference, little innovation	less price-conscious customers who value uniqueness, products whose features keep changing	customers, regions or products that broad competitors find hard to serve
Risks	cost inflation and lost discipline; technology that changes costs or market share; customers wanting better quality (premiumization)	imitation; more sophisticated buyers; a premium that becomes excessive; exclusivity that caps market share	large competitors undercut on price; the groups become more alike; more sophisticated buyers

Exam tip Premium price, brand and features: differentiation. Lowest cost, volume and low prices across the market: cost leadership. One narrow segment: focus, and then ask which kind. Lowest price in the niche is cost-based focus; a unique product at a premium in the niche is differentiation-based focus. Scale and scope economies point to cost leadership, not to focus.

How does the evaluation come together?

Match the strategy to the earlier work. If the survey shows a mature, price-driven industry with strong customers, cost leadership has the logic of the Five Forces behind it. If PESTLE shows that customers increasingly value sustainability, a strategy that fights that trend fails the second test. If the company lacks the capital or skills, the third test fails regardless. A move that conflicts with the chosen strategy should be questioned: a differentiator that matches rivals’ discount prices gives up its premium, and a cost leader that starts adding premium features risks losing the cost lead that defines it.

Go deeper Low-cost producers in commodity industries

In an industry of identical products with easy entry, returns on capital drift toward the cost of capital. The exception is the low-cost producer, whose costs sit well below those of the marginal producer. It keeps a margin even when prices fall to the marginal cost, so it can earn above its cost of capital for as long as the lead lasts. The lead is not permanent: technology, input prices and rivals’ investment can erode it. Lesson 3 returns to this when it looks at price takers.