Porter's Generic Strategies and how to use them

As far back as 1980, Michael Porter wrote that all firms must choose to compete on the basis of either cost leadership, differentiation or focus. Firms which attempt to compete on more than one of these three risk wasting precious resources with incompatible strategies. Porter described such firms as "stuck in the middle".

Cost Leadership

In cost leadership strategies, firms compete by lowering prices (relative to value) in order to appeal to a broader target market (especially cost-conscious customers who might otherwise not purchase the product) or to sell higher volumes of product to existing customers.

Cost leadership firms retain profitability by keeping costs low through:

1. increasing asset utilisation: for example, an airline that can turn aircraft around more quickly at the gate, a restaurant that can turn tables more quickly, or a management consultancy can charge more billable hours per member of staff and/or have fewer support staff, a factory can run expensive machinery 24 hours a day, etc.
2. increasing economies of scale: for example, manufacturers that produce and sell higher volumes of goods can negotiate better deals on raw materials and distribution, and use more specialised equipment and processes.
3. utilising the experience curve: for example, firms that repeat processes more frequently and over a longer period of time can use statistical and other methods to learn about and improve those processes.
4. standardisation: offering few options on products and services, like the Model T Ford "any colour as long as it is black" approach. This will help to drive asset utilisation, economies of scale and the experience curve.
5. process innovation: for example, by finding a substantially cheaper way to produce something.
6. employing other low-cost strategies, including operating from low-cost locations, outsourcing, etc.

Firms pursuing cost leadership can deter new entrants to their market by threatening to retaliate with reduced prices. They can lock in powerful distributors with attractive deals, and neutralise supplier bargaining power. Given low prices, customers are less likely to consider more expensive substitute products or services. Rivalry can become an issue if two cost leaders enter into a price war, commoditising the market and competing all of the profits away.

Differentiation

In differentiation strategies, firms compete by offering superior products or services to customers, usually at higher prices.

Firms achieve differentiation through:

1. customer intimacy: having strong relationships with their customers and knowing what they want and value.
2. product or service innovation: developing new products, services and features to satisfy those wants and needs (learn more).
3. brand building: to convince customers that a firm's products or services are somehow superior to a greater extent than what they really are, or to convince customers that they want product or service features the firm offers more than they actually need them.

Firms must find ways to protect their differentiators, for example using copyrights, patents, and/or exclusive/monopoly contracts. If their differentiators can be replicated by competitors, they will lose their competitive advantage and may be forced to compete on price against firms which lead on cost.

Firms using differentiation must rely customer loyalty to fend of new entrants. Differentiators can negotiate with distributors on the basis of such customer loyalty and brand pull - that is consumers will want distributors to carry their products. Differentiators have less bargaining power with suppliers but are better able to pass supplier price increases to customers. Differentiators rely on the utility of their value-added features to fend of substitutes. Rivalry is resolved by convincing customers of the superiority of the product or service, which can require clever marketing. 

Focus

Firms achieve focus by targeting one or more specific customer segments or niches. They then pursue a strategy of differentiation with regard to the product and service features with the attributes most highly desired by those segments, and cost leadership (or even elimination) with all other attributes.

Whilst focus combines elements of both differentiation and cost leadership, it should not be seen as a hybrid or blend of the two. Strict separation should be made between those product and service attributes where cost leadership is to be applied and where differentiation is to be applied, and this strict separation should be based on the particular wants and needs of clearly identified niches.

How to use the generic strategies

1. Decide which of the three generic strategies you want to pursue
   
   It is often, but not universally true that larger firms must choose between cost leadership and differentiation, whilst smaller firms must pursue focus. This is usually because large firms will struggle to find niches of sufficient size, and because small firms lack the resources to compete on cost leadership or differentiation.
   
   In large businesses, such as conglomerates, it is possible to for different part of the business to compete using different generic strategies. In such cases, the business may pursue different generic strategies under different brands in order to maintain that distinction in the market.
   
   
2. Actively develop strategies and pursue which are aligned to and strengthen that position
   
   See the three descriptions above for examples of the kinds of strategies you might pursue under each of the three generic strategies.
   
   
3. Identify and phase out any activities you currently undertake which do not support your chosen generic strategy.
   
   
4. When evaluating new opportunities, eliminate those which are not compatible with your chosen generic strategy.