Chapter 6:

Business strategy: differentiation, cost leadership, and integration

6.1 Business Level strategy: how to compete for advantage

Business level strategy details the goal directed actions managers take in their quest for
competitive advantage when competing in a single product market.

Business level strategy may involve a single product or a group of similar products that
use the same distribution channel. Business level concerns the broad question “How
should we compete?”.

To formulate an appropriate business level strategy, managers need to answer the “who-
whatwhyandhow” questions of competition.

Who → Which customer segments the firm wants to serve What →Which customer
needs, wishes, and desires the firm want to satisfy Why → Why the firm wants to satisfy
the customer needs, wishes and desires How → How the firm will satisfy its customers’
needs.

To formulate an effective business strategy, managers need to keep in mind that

competitive advantage is determined jointly by industry and firm effects.

An industry’s profit potential can be assessed using the five forces framework plus the
availability of complements. Managers need to be certain that the business strategy is
aligned with the five forces that shape competition.

Managers can evaluate performance differences among clusters of firms in the same
industry by conducting a strategicgroup analysis.

A firm effects because they allow us to look inside firms and explain why they differ
based on their resources, capabilities, and competencies. It is also important to note that
industry and firm effects are not independent, but rather they are interdependent, as
shown by the two-pointed arrow connecting industry effects and firm effects

At the firm level, performance is determined by value and cost position relative to
competitors. This is the firm’s strategic position.
STRATEGIC POSITION

Competitive advantage is based on the difference between the perceived value that the
firm is able to create for a customer (V) captured by how much consumers are willing to
pay for a product or service, and the total cost (C) the firm incurs to create that value.
To answer the businesslevel strategy question of how to compete, managers have 2
primary competitive levers at their disposal: value (V) and cost (C).

A firm’s businesslevel strategy determines its strategic position, which is its strategic
profile based on value creation and cost, in a specific product market.

A firm attempts to stake out a valuable and unique position that meets customer needs
while simultaneously creating as large as gap as possible between the value the firm’s
product creates and the cost required to produce it. Higher value tends to require higher
cost.

To achieve a desired strategic position, managers must make strategic tradeoffs which
are choices between a cost or value position.

Managers must address the tension between value creation (which tends to generate
higher cost) and the pressure to keep cost in check so as not to erode the firm’s economic
value creation and profit margin.

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
that result creating more value or offering similar product or services at lower cost.

GENERIC BUSINESS STRATEGIES

There are 2 fundamentally different generic business strategies: differentiation and cost
leadership.

A differentiation strategy seeks to create higher value for customers than the value that
competitors create by delivering products or services with unique features while keeping
costs at the same or similar level.
A cost leadership seeks to create the same or similar value for customers by delivering
products or services at a lower cost than competitors, enabling the firm to offer lower
prices to its customers.

These 2 strategies (differentiation and cost leadership) are called generic strategies
because they can be used by any organization in the quest for competitive advantage,
independent of industry structure.

Differentiation and cost leadership require distinct strategic positions in order to

increase a firm’s chances to gain and sustain a competitive advantage.

Because value creation and cost tend to be positively correlated, there exist important
tradeoffs between value creation and low cost.
Can different generic strategies lead to competitive advantage in the same industry?

Yes, different generic strategies can lead to competitive advantage, even in the same
industry. Ex: Rolex and Timex.

When considering different business strategies, managers must also define the scope of
competition. The scope of competition is whether to pursue a specific, narrow part of the
market or to go after the broader market. Ex: Rolex focuses on a small market segment:
affluent consumers who want to present a certain image. Timex offers watches for many
different segments of the mass market.
When we combine the dimensions describing a firm’s strategic position
(differentiation and cost with the scope of competition (narrow and broad), we get 2
major broad business strategies: cost leadership and differentiation. We also get the
focused versions of each: focused costleadership strategy focused differentiation
strategy These 2 focused versions are essentially the same as the broad generic strategies
except that the competitive scope is narrower.

6.2 Differentiation strategy: understanding value drivers

The goal of a generic differentiation strategy is to add unique features that will increase
the perceived value of goods and services in the minds of the consumers so they are
willing to pay a higher price.

A firm following a differentiation strategy aims to achieve in the minds of consumers a

level of value creation that its competitors cannot easily match. The focus of competition
in a differentiation strategy can achieve tends to be on unique product features, service,
and new product launches, or on marketing and promotion rather than price. A company
that uses a differentiation strategy can achieve a competitive advantage as long as its
economic value created (VC) is greater than that of its competitors.

Although increased value creation is a defining feature of a differentiation strategy,

managers must also control their costs. Rising costs reduce economic value created and
erode profit margins. Indeed, if cost rises too much as the firms attempts to create more
perceived value for customers, its value gap shrinks, negating any differentiation
advantage.
Although a differentiation strategy is generally associated with premium pricing,
managers have an important second pricing option. When a firm is able to gain market
share from other firms by charging a similar price but offering more perceived value.

What levers can managers adjust to improve a firm’s strategic position?

Managers can adjust a number of different levers to improve a firm’s strategic position.
They are: product features, customer service and complements.

Marriott offers a line of different hotels: its flagship Marriott full-service business hotel
equipped to host large conferences; Residence Inn for extended stay; Marriott Courtyard
for business travelers; and Marriott Fairfield Inn for inexpensive leisure and family
travel.9 Although these hotels are roughly comparable to competitors in price, they
generally offer a higher perceived value. This difference between price and value allows
Marriott to gain market share and post superior performance.

PRODUCT FEATURES

One of the obvious but most important levers that managers can adjust are the product
features and attributes, thereby increasing the perceived value of the product or service
offering. Adding a unique product feature allows firms to turn commodity products into
differentiated products commanding a premium price.
Strong R&D capabilities are often needed to create superior product features.

CUSTOMER SERVICE

Managers can increase the perceived value of their firms’ product or service by focusing
on customer service and responsiveness.

COMPLEMENTS

Complements add value to a product or service when they are consumed in tandem.
Finding complements, therefore, is an important task for managers in their quest to
enhance the value of their offerings.

Increasing the perceived value of firms that choose a differentiation strategy:

By choosing the differentiation strategy as the strategic position for a product, managers
focus their attention on adding value to the product through its unique features that
respond to consumer preferences, customer service during and after the sale, or an
effective marketing campaign that communicates the value of the product’s features to
the target market. Although this positioning involves increased costs, customers will be
willing to pay a premium price for the product or service that satisfies their needs and
preferences.
6.3 Cost leadership strategy: understanding cost drivers

The goal of cost leadership strategy is to reduce the firm’s cost below that of its
competitors while offering adequate value. The cost leader focuses its attention and
resources on reducing the cost to manufacture a product or deliver service in order to
offer lower prices to its customers. The cost leader optimizes all of its value chain
activities to achieve a low cost position.

Although staking out the lowest cost position in the industry is the overriding (dominant)
strategic objective, a cost leader still needs to offer products and services of acceptable
value.

A cost leader can achieve a competitive advantage as long as its economic value created
(VC) is greater than that of its competitors.

Although companies successful at low cost leadership must excel at controlling costs, this
doesn’t mean they can neglect value creation. Firm B, a cost leader, achieves a
competitive advantage over Firm A because Firm B not only has lower cost than Firm A,
but also achieves differentiation parity (meaning it creates the same value as Firm A).

That if Firm B fails to create differentiation parity? Such parity is often hard to achieve
because value creation tends to go along with higher costs, and Firm B’s strategy is
aimed at lower costs. Firm B can still gain a competitive advantage as long as its
economic value creation exceeds that of its competitors.
**The most important cost drivers that managers can manipulate to keep their costs low
are: Cost of input factors -Economies of scale - Learning curve effects - Experience
curve effects

COST OF INPUT FACTORS One of the most basic advantages a firm can have over
its rivals is access to lower cost input factors such as raw materials, capital, labor and IT
services. To lower labor costs for some types of tasks, some companies outsource
certain activities.

ECONOMIES OF SCALE: Economies of scale are decreases in cost per unit as output
increases. Used in Airframe manufacturing industries. Firms with greater market share
might be in a position to reap economies of scale, decreases in cost per unit as output
increases. This relationship between unit cost and out-put is depicted in the first. Cost per
unit falls as output increases up to point Q1. A firm whose output is closer to Q1 has a
cost advantage over other firms with less output. In this sense, bigger is better.
1. Spreading fixed cost over larger outputs: larger output allows firms to spread their
fixed costs over more units. That is why gains in market share are often critical to
drive down per-unit cost.  Microsoft spend Billions on their R&D to develop
Windows 7, once they create it and started selling it  production cost decreased.

2. Employing specialized systems and equipment: larger output also allows firms to
invest in more specialized systems and equipment, such as enterprise resource
planning (ERP).

3. Taking advantage of certain physical properties: one such property is known as the
cubesquare rule whereby firms can stock much more merchandise and handle
inventory more efficiently. This same principle makes big-box retail stores such
as Walmart, Best Buy, the Home Depot, and Toys“R”Us cheaper to build and run.
Their huge size makes it difficult for department stores or small retailers to
compete on cost and selection
→ The minimum efficient scale (MES) is the output range needed to bring the
cost per unit down as much as possible, allowing a firm to stake out the lowest
cost position achievable through economies of scale. (Check graph between Q1
and Q2) → The concept of minimum efficient scale applies not only to
manufacturing processes but also to managerial tasks such as how to organize
work. Diseconomies of scale are increases in cost as output increases. (Beyond
Q2) As firms get too big, the complexity of managing and coordinating raises the
cost, negating any benefits to scale.

LEARNING CURVE Learning by doing can also lower costs. Teams and employees
that engage in an activity learn from their cumulative experience (developing codes…).
The more complex the production process, the more learning effects we can expect. 
First experienced in aircraft manufacturing As cumulative output increases, managers
learn how to optimize the process and workers improve their performance through
repetition.

Differences between economies of scale and learning effects:

Learning effects can occur over time as output is accumulated, while economies of
scale are captured at one point in time when output is increased.
 In some production processes (simple onestep processes for example), effects from
economies of scale can be quite significant, while learning effects are minimal.

-In contrast, in some professions (brain surgeries or the practice of estate law), learning
effects can be substantial, while economies of scale are minimal.

Managers need to understand this subtle but important difference in order to calibrate
their business-level strategy. For example, if a firm’s cost advantage is due to economies
of scale, a manager should be less concerned about employee turnover (and thus a
potential loss in learning) and more concerned with drops in production runs. In contrast,
if the firm’s low-cost position is based on complex learning, managers should be much
more concerned if a key employee (e.g., a star researcher at a pharmaceutical company)
was to leave.

EXPERIENCE CURVE

The concept of experience curve attempts to capture both learning effects and process
improvements. A firm can gain competitive advantage by moving further down a given
learning curve than competitors. Learning by doing allows a firm to lower its perunit cost
by moving down a given learning curve.

Process innovation—a new method or technology to produce an existing product—may

initiate a new and steeper learning curve. Experience-curve effects (learning effects plus
process innovation),

Combining experiencebased learning and process innovation allows the firm to leapfrog
to a steeper learning curve, thereby further driving down its perunit costs.

By choosing a cost-leadership strategy, managers must focus their attention on lowering

the overall costs of producing the product or service while maintaining an acceptable
level of quality that will serve the needs of the customer. Cost leaders appeal to the price-
conscious buyer, whose main criterion is the price of the product or service. By attending
to the reduction of costs in each value chain activity, managers aim to achieve the lowest
cost position in the industry. This provides the ability to offer the lowest price in the
market and the consequent ability to attract an increased volume of sales. As successful
cost leaders such as Walmart illustrate (“Every Day Low Prices”), this strategic position
can be a very profitable business
6.4 Businesslevel strategy and the five forces: benefits and risks

6.5 Integration strategy: combining cost leadership and differentiation

Competitive conditions in an industry may require firms to develop skills in lowering

costs as well as adding uniqueness. An integration strategy / blue oceans is a business-
level strategy that successfully combines differentiation and costleadership activities.

A successful integration strategy requires that tradeoffs between differentiation and low
cost are reconciled. This is often difficult because differentiation and low cost are distinct
strategic positions that require the firm to effectively manage internal value chain
activities that are fundamentally different from one another. Ex: Cost L focuses his R&D
on process technology for efficiency while D focuses on product technology for
uniqueness. An integration strategy allows a firm to offer a differentiated product or
service at low cost.
-The consequence of an integration strategy gone bad is that the firm ends up being
“stuck in the middle”, meaning the firm has neither a clear differentiation strategy nor a
clear costleadership profile.

-The goal of an integration strategy is to achieve a larger economic value created than
that of rivals pursuing a differentiation or low-cost leadership strategy.  Competitive
advantage.

**A successfully implemented integration strategy allows firms 2 pricing options:

the firm can charge a higher price than the cost leader, reflecting its
higher value creation and thus generating greater profit margins.

the firm can lower its price below that of the differentiator because of its
lowercost structure. If the firm offers lower prices than the differentiator, it can
gain market share and make up the loss in margin through increased sales.

VALUE & COST DRIVERS OF INTEGRATION STRATEGY

For an integration strategy to succeed, managers must resolve tradeoffs between the 2
generic strategic positions: low cost and differentiation.

**Some possible levers managers can use to overcome these challenges include:

Quality Economies of scope Customization Innovation Structure, culture, and routines

QUALITY: The quality of a product denotes its durability and reliability. Quality not
only can increase a product’s perceived value, but also can lower its cost. Through
techniques such as Total Quality Management companies are able to design and build
their products with quality in mind while being different. Quality is a two-pronged
activity: It raises economic value creation (V - C) by simultaneously increasing V and
lowering C.

ECONOMIES OF SCOPE: The concept of economies of scope describes the savings

that come from producing 2 or more outputs at less cost than producing each output
individually, even though using the same resources and technology. Starbucks: Coffee
and tea- hot water/As a result, Starbucks lowers its cost structure by sharing its
production assets over multiple outputs, while increasing its menu and thus its
differentiated appeal.

CUSTOMIZATION: Customization allows firms to go beyond merely adding

differentiating features to tailoring products and services for specific customers.
Advances in manufacturing and information technology have made feasible mass
customization. Mass customization is the manufacture of a large variety of customized
products or services done at a relatively low unit cost. Toyota was the first to introduce
lean manufacturing, allowing it to mass customize vehicles and produce higher quality at
a lower per-unit cost
INNOVATION: Innovation describes any new product and process, or any modification
of existing ones. Innovation is frequently required to resolve existing tradeoffs when
companies pursue an integration strategy. IKEA uses innovation in furniture design,
engineering, and store design to solve the trade-offs between value creation and
production cost

STRUCTURE, CULTURE AND ROUTINES A firm’s structure, culture, and routines

are critical when pursuing an integration strategy. The challenge that managers face is to
structure their organizations so that they both control cost and allow for creativity that
can lay the basis for differentiation.

The goal for managers who want to pursue an integration strategy should be to build an
ambidextrous organization which is an organization that enables managers to balance
and harness different activities in tradeoff situations: here, the trade-off is the
simultaneous pursuit of low cost and differentiating strategies.

These levers are critical: they allow managers to simultaneously increase perceived value
and lower cost.

INTEGRATION STRATEGY GONE BAD: “STUCK IN THE MIDDLE”

An integration strategy is quite difficult to translate into reality because differentiation

and cost leadership are distinct strategic positions that require important tradeoffs.

An integration strategy is difficult to implement because it requires the reconciliation of

fundamentally different strategic positions (differentiation and low cost), which in turn
require distinct internal value chain activities in order to allow the firm to increase value
and lower cost at the same time.

Many firms that attempt to pursue an integration strategy fail because they end up being
stuck in the middle: they succeed at neither a differentiation nor a cost leadership
strategy. In a world of strategic tradeoffs, increasing value and lowering cost have
opposite effects. For example, improved features, customer services, and customization
all result in higher cost while offering a nofrills product reduces perceived value.

6.6 The dynamics of competitive positioning

Companies that successfully implement one of the generic business strategies

(differentiation or cost leadership) are more likely to attain competitive advantage. To do
so, companies seek to reach the so-called productivity frontier.
The productivity frontier is the valuecost relationship that captures the result of
performing best practices at any given time. Firms that exhibit effectiveness and
efficiency reach the productivity frontier, others are left behind.

The productivity frontier represents a set of bestinclass strategic positions the firm can
take relating to value creation and low cost at a given point in time. A firm’s business
strategy determines which strategic position it aspires to along the productivity frontier.
Strategic positions are not fixed. They can, and need to, change as the environment
changes. It is critical for managers, therefore, to understand the dynamic of competitive
positioning, or how strategy shapes a firm’s position over time.

Reaching the productivity frontier at a given point in time increases the likelihood of
achieving a competitive advantage. Falling behind the productivity frontier results in
competitive disadvantage.

Changes in industry environment allow firms to stake out more valuable positions and
turn inferior performance into a competitive advantage.

6.7 Implications for the strategist

Strategic positioning is critical to gaining competitive advantage. Wellformulated and

implemented generic business strategies enhance the firm’s chances of obtaining superior
performance. Strategic positioning requires making important tradeoffs.

In rare instances, firms are able to reconcile the significant tradeoffs between increasing
value and lowering production costs by pursuing both business strategies (differentiation
and low cost) simultaneously. These integration strategies tend to be successful only if a
firm is able to rely on an innovation that allows it to reconcile the tradeoffs involved in an
integration strategy.

Given the dynamics of competitive positioning, firms cannot stand still but must
constantly refine and improve their strategic position over time. The goal is to not fall
behind the productivity frontier, which is defined by the theoretically possible best
practice at any given time.