cost leadership and differentiation; an investigation of the fundamental trade-off
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Cost Leadership and Differentiation - Cost Leadership and Differentiation An Investigation of the Fundamental Trade-Off.TRANSCRIPT
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Cost Leadership and Differentiation; An Investigation of the Fundamental Trade-Off
between Low Cost Leadership and Differentiation Strategies
CHAPTER ONE
1.1 Abstract
Strategy as applied in business organizations is a rather complex and broad concept. In his
definition, Porter (1996) defines strategy as the ‘creation of a unique and valuable position
involving different sets of activities.’ Basically, strategic positioning aims at choosing activities
that have the potential to yield superior profitability because they happen to be quite different
from those of the rivals and thereby create a sustainable competitive advantage. However, no
competitive advantage can be completely enduring and that is why strategy should be
distinguished from the other closely related concept, operational efficiency.
In order to investigate the issue of trade-off between differentiation and cost leadership, an
incisive literature review has been conducted. This is correspondingly accompanied by a cross-
check evaluation of the contemporary business position in respect of the matter. In particular,
this research study examines whether cost leadership and differentiation strategies are mutually
exclusive. When one considers the impact of Porter’s model and in specific on managers, it is of
paramount importance that one takes a critical look.
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The traditional believe that differentiation and low cost leadership are mutually exclusive has
been strongly embraced by some modern practitioners and yet others are of the view that it does
not hold any relevance in the face of modern business practices. Several researchers into the
topic have actually questioned the existence and if the relevance of the inevitable trade-off
between the two strategies. If the traditional view of the inevitable trade-off between the two
concepts proves inconsistent with the current state of affairs but a mixed strategy combining the
two proves appropriate, then business executives need to reconsider their strategic choices.
1.2 Research Objectives
To investigate the fundamental trade-off between low cost leadership and differentiation
strategies
1.3 Purpose of research
This dissertation explores the existing literature on the fundamental trade-off between
differentiation and low cost leadership business strategies. Practical applications and concepts
about the compatibility of the two strategies will be reviewed thoroughly as a complement to the
theoretical literature so as to shed some light on the inherent relationship between theory and
practice. The research is not necessarily intended to be used by any government or institution in
implementation of policies but will generally add more knowledge to the existing literature by
producing new insight on generic strategies and specifically the incompatibility between
differentiation and cost leadership strategies.
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CHAPTER TWO: LITERATURE REVIEW
2.1 Low Cost Leadership and Differentiation as Strategies for Achieving Competitive
advantages
Competitive advantages in organizations can be achieved through cost leadership. This has the
implication to the fact that, for the organization to successfully gain a competitive edge, it must
consider a production process that is of the lowest cost as compared to other players in the
industry (Oskarsson & Sjöberg, 1994). To be a cost leader, the organization likewise should be
achieving parity of the least proximity with regard to differentiation even if it may be dependent
on the cost leadership associated with the competitive advantage of the firm. It becomes a
disastrous situation whereby several companies operating in the same industry strive for the
achievement of cost leadership. This type of a competitive advantage is better achieved as a
result of a practice of economies of scale (Miller & Friesen, 1986).
Any improvement in quality cost strategies results in corresponding increase in the cost of
production. Consequently, increased cost may result in reduced demand and as such
differentiation limits market share. However, the negative relationship between market share and
differentiation does not impact much on the profitability margin since premium prices are
justified by increased cost (Roth, 1992). While the two concepts can generate significant
competitive advantage which in turn improves business performance, operational efficiency is
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easy to imitate and as such, the competitiveness stands a risk of erosion. Actually researchers
claim that the main threat to sustaining a competitive advantage can always diagnose and make
exact duplication or in some cases render obsolete a firm’s competitive advantage.
A competitive advantage in an organization may also be achieved through differentiation. The
achievement of differentiation has the implication of the fact that, the organization strives
towards uniqueness in relation to other players in the industry in consideration of specific
dimension which most of the consumers appreciate to a great degree. The use of differentiation
requires that the cost position is not ignored (Miller & Friesen, 1986). All the segments that have
a significant impact on the differentiation should not tend towards the decrease in cost. With
regard to the area of differentiation, the cost should be kept at a lower stage relative to the
premium price that the customers are ready to offer. Differentiation can be based on areas such
as the product, the image, service rendered, sales, marketing or distribution.
The type of strategy that a business employs and performance it achieves are positively
correlated (Oskarsson & Sjöberg, 1994). The positive effects of increased differentiation on
market share depends on two factors; the uniqueness of the differentiation strategy and the
perceived effect of the strategy. Increased differentiation should be correspondingly translated
into product improvement so that the cost reduction effect can take place. The reason for this is
that increased product quality results in beneficial effects on the relative product demand. So if
increased demand is governed by increase in sales volume, then there might be certain beneficial
effects on cost positioning through positive and direct influence on market position (Roth, 1992).
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According to what Porter states, with the onset of imitation of successful firms by the
competitors, there is a high possibility that they will be under pressure of choosing between the
lower cost and the issue of differentiation. There is a possibility for the improvement of
technology by the firms coupled the approaches that lead to the reduction in cost in a
simultaneous manner with the improvement of differentiation. At the end of it all, the
competitors will be compelled towards the imitation and a tendency of making a choice which
will result in emphasizing advantage (Miller & Friesen, 1986).
Businesses that use differentiation strategy also use low cost leadership strategy to a certain
extent. The cost leadership strategies also demonstrate certain traits associated with
differentiation. According to Roth, (1992), there are no businesses that employ pure strategies
and as such both low cost leadership and differentiation strategies are usually used
simultaneously. Roth, (1992) argues that the underlying dimension is not low cost versus
differentiation but low cost versus high cost. This researcher claims that it is low cost and high
costs that lie on opposite ends of a continuum. Therefore, if a business chooses to pursue a cost
strategy, it should consider the low cost approach but if it chooses to pursue a differentiation
strategy then the business has to consider adopting high cost approach (Miller & Friesen, 1986).
Porter’s model in effect implies that if all firms are placed on the continuum, firms with above
average profit would be found at the ends of the continuum. Any other point on the continuum
which does lie on the ends implies an unclear strategy. This is what is commonly called ‘stuck in
the middle’. This means a trade-off can be inevitable if a business cannot move away from one
end without its strategies becoming unclear which may eventually cause it to lose profits. Thus,
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while the proponents of porters argue that cost leadership and product differentiation are
irreconcilable, the opponents hold that a trade-off between the two strategies does not necessarily
have to be (Oskarsson & Sjöberg, 1994).
It is however to the acknowledgement of Porter that, an organization may achieve high strides of
success as they tend to pursue the lower cost along with differentiation at the same time in their
endeavor to the achievement of a competitive advantage (Roth, 1992). The reduction of cost is
not an automatic implication of sacrificing on differentiation. Appreciable results may be
achieved though the use of practices that result in a higher degree of efficiency as well as
effective through the employment of a diversity of technology. According to the suggestions of
Porter, there arises some rare occasions in which some organizations achieve success as a result
of combining both the approaches intended at achieving a competitive edge Porter, M.E. (1988).
2.2 Examining the divergence point
High differentiation and low cost position are just but two unique ways of gaining competitive
advantages (Miller & Friesen, 1986). Essentially, both strategies are governed by certain
relationships which hint to an interaction effect between them. Thus an effective business firm
cannot in any way afford to put special emphasis on only one business strategy at the expense of
the other. Recent studies on cost leadership and differentiation cut-off reveal clear differences in
the conception of differentiation and cost leadership strategies but all point to the fact that there
is no any one single strategy that can be utilized for effective performance. Differentiation
strategy comprises of a large number of interrelated elements such as quality guarantee but
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superiority quality is the only one that is mostly associated with the strategy. In effect,
superiority in quality is perceived to be a major determinant of differentiation not only in studies
but also in tests and researches (Parker & Helms, 1992).
At such instances, the firms were in apposition of reaping high profiles of benefits as compared
to other organizations that opted for one approach to competitive advantage. The potential ability
of an organization towards the achievement of cost leadership together with differentiation at the
same time leads to higher rewards coupled with additive form of benefits with differentiation
resulting to the achievement of premium prices while cost leadership brings about lower costs
Porter, M.E. (1988). Porter’s conceptualization models have been heavily criticized by even
some of the proponents of Porter’s school of thought. For instance, Hambrick, (1983) argues that
it might be true that differentiation and efficiency are incompatible but they cannot be opposite
ends of a single continuum as Porter presents them. Dess and Davis, (1984) claim that
competitive strategies can be represented as broad types of strategic groups. This means that cost
leadership makes out one group and this includes all strategies that are similar and have certain
aspects in common.
High cost differentiation can limit a business’ potentiality to reap economies of scale and hence
the market share. Nurturing a good relationship between market share and differentiation is
fundamental for the success of a business. Thus, no single business no matter its size or nature of
business can maintain its competitive edge in the market without embracing certain aspects of
the differentiation strategy (Roth, 1992). The model of generic strategies as originally postulated
by Porter in 1980 addresses business practitioners with an evaluative technique for gaining
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understanding of industry trends and competitors. By practitioners, Porter means all business
managers interested in improving the performance of their businesses or security analysis
strategies attempting to understand or forecast business failure or success. The reason for
strategic planning being an issue of primary concern for business managers is that it can easily
lead to immense benefits for the firm (Phillips et al, 1983).
For the firm that takes the option of achieving a competitive advantage through lower cost, their
focus is usually on improving the profitability arising due to lower costs as compared to others in
the same industry. Putting, the value of the product at a lower cost but near that one of the
competitors is tantamount to translating to superior returns. This therefore implies that lowering
the cost of the products results to advantage since this encourages the consumers to buy more
due to the reason that they access products of a higher value at a reasonably low cost (Parker &
Helms, 1992). Strategies can be well reconciled (i.e. without trade-off) since firms can introduce
skills to suit both strategies at the same time. As a matter of fact, strategies that are combined are
less likely to run into risks related with pure strategies i.e specialization (e.g. mller,1988; wright
et al,1991). Quoting Miller (1988), strategic specialization may result in ”major gaps or
weaknesses in product offerings, fail to consider important customer needs, be simple for
competitors to counter, and ,after some time, bring inflexibility and lessen an organizations
vision . “Miller (1998) states that caterpillar originally tried to be the highest-quality producer of
earth-movers world wide by paying attention only to durability and precision but failed to
consider efficiency and economy.
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Considering the disparities that exist between the two models however indicates that they both
have some features in common (Parker & Helms, 1992). One of the most notable features is the
management of the value chain which is an avenue towards competitive advantage, and with a
continuous improvement of the value chain. This also facilitates that the product acquires an
extremely higher value relative to the competitors. The common feature are important in that
they facilitate that the models are applicable simultaneously towards the creation of a
competitive advantage on the basis of a higher order, which is in essence next to impossible to
create an imitation of a competitive advantage (Porter, 1988).
Product differentiation and cost leadership are interesting as well as popular research topics
within the wider area of strategy. The two topics have been widely discussed ever since Porter
advanced his model of generic business strategies in the 1980s. Modern day researchers into the
topic in fact refer to it as being among the most important contributors of literature on strategic
business management. However, the issue of whether cost leadership and differentiation are
mutually exclusive ahs not been adequately discussed and this as Phillips et al, (1983), claim can
be evidenced by elative scarcity of literature on the topic.
Differentiation on the other hand makes out the second group and this constitutes all strategies
that are similar and all contains certain elements that are generally associated with differentiation
though these do not have to be identical. Roth, (1992) supports this view and assets that choosing
a business strategy is akin to choosing strategic group membership. Each group will have its own
unique features which are not reconcilable and therefore a business can be a member in one
strategic group only. Several attempts have been made to combine cost leadership and
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differentiation but most of these have failed because the two groups are essentially incompatible.
This according to Miller, (1992), means that a trade-off between cost leadership and
differentiation is inevitable because the two strategies are mutually exclusive.
2.3 The concept of combined strategy
According to Porter, adopting a “single” strategy successfully requires total commitment;
thereby implementing two strategies needs an excessive effort. Chakraborty & PHILIP (1996),
states that some firms follow a mixed approach is due to difficulty in designing and
implementing an effective extensive strategy laid according to the two approaches. Since cost
leadership and differentiation strategies demand different resources, skills, organizational
arrangements and managerial styles that are hard and also incompatible to reconcile, efforts to
reconcile the two finally result to a trade-off. For example competition between cost leadership
and differentiation strategies require resources and technologies of functional support that stress
cost cutting throughout” the total functional areas of the organization.
Campbell-Hunt (2000) states that organizational constraints generally represent the main reason
why cost-and differentiation-strategies designs are known to be mutually exclusive. Strategies
are also exposed to various risks and hence require different guards, which on the other hand,
could be incompatible or even opposed to each other(Wright & Parsinia , 1988).Thus even if the
two strategies stress on profits and performance their approaches differ ( Chakraborty & Philip,
1996). Making a decision on which strategy to employ implies matching “strategic
requirements” with the firm’s resources, capabilities and short comings. Anyhow, since a firm
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has limited materials, it is an favorable to all strategies.( Porter,1980,Wright &
Parinsia,1988;Barney,2002).By being ‘all things to all customers’ a firm is in danger of
becoming too wide and finally answering to no particular customer or market segment
(Porter ,1980; Akan et al, 2006;Chakraborty & Philip,1996).
Grant (2005) for example names it as “one of the greatest strategic challenges of the 1990s”.in
relation to Murry (1988), the points that prefer cost leadership are free from conditions that
prefer differentiation and so there is no favored reason to rule out the likely hood of reconciling
cost and differentiation based on outside conditions .Contrary, outside conditions can very well
prefer mixed strategies, on condition that differentiation and market is positive, differentiation
may generate economies of scale ,equally meaning that higher differentiation and cost
reductions are arrived at the same time .As observed earlier differentiators demand a higher
price(originally justified by higher production cost strategies and product uniqueness).Hence
mixing strategies with success means that a firm may charge a higher price(than cost leaders)
while lowering cost strategies (compared to differentiators), leading to superior profits.
Excessive focus on a single point, strategy or strength risks lowering resilience and adaptability
in he long run. Combination strategies ,promote flexibility and makes it simple for firms to get
accustomed to changes, such as, advances in technology and changes in industry( Miller, 1992;
Parker &Helms,1992).Miller (1992), (Barney (2002) and Barney & Hesterly (2006) suggest that,
firms that are successful both in cost leadership and product differentiation ,can be expected to
have a sustained competitive advantage .As a matter of fact, combination of cost leadership and
differentiation can be expected to benefit from competitive cost advantage.
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A combination of cost leadership and differentiation strategies produces complex relations, e.g.
among employees, between employees, the technology in use, and the firm which they belong to.
The reason is because mixed strategies engage a lot of resources and organizational support.
Therefore, as long as the organizational strengths and weaknesses applied are rare, scarce and
expensive to imitate, the socially complex relations that materialize when reconciling strategies
constitute an origin of sustained competitive advantage (Miller, 1992; Berney, 2002; Berney &
Hesterley , 2006).
Phillips et al, (1983), advocates that a trade-off does not have to be mixed. Strategies can
generate superior performance as they have the capability to create socially complex relations
that market sham scarce, rare and costly to imitate, while Porter’s argues that mixed strategy is a
poor choice. Researches show that maximization of profit entails setting preferences foe
effective strategies that ultimately adopt low cost and premium prices if at all they have to result
in superior profits. If there were no trade-offs, all business practitioners should be adopting
combination rather than one single strategy. Evidently, this has never been the case, which in
turn suggests that a trade-off exist. In fact, most researchers concur that attempts to adopt
differentiation and cost leadership simultaneously tend to generate a trade-off. However, if a firm
successfully reconciles both strategies, efforts will be compensated by high performance.
2.4 Examining the relationship between combined strategy and market share
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Saloner et al, (2004) claim that differentiation leads to higher market share provided that the
product appeals to customers. This implies that a business firm has to identify and pursue its
customer preferences if it has to gain increased market shares by way of differentiation.
Specifically, customers will always want to get favorable products as characterized by such
aspects as firm’s resources, processes, skills and history. Differentiation as a strategy allows a
business firm to increase its market share through decreased price elasticity of demand.
Another school of thought rejects the argument forwarded by Porter and followers of his school
of thought. Cost leadership and differentiation are seriously taken to be reconcilable and even
hunted-for. A successful combined strategy produces superior profits according to some
researchers. But, this does not mean that a successful mixed strategy is simple to achieve; in fact,
from the opposite school of thought the challenge is noticeable. Great efforts are required in
adopting mixed strategy successfully (Reddy, 1980; Chakraborty & Philip,1996;Wright et al,
1986;Grant,2005).
Reitsperger, (1998) suggest a very similar explanation offering that differentiation strategy better
position a firm to offer a large product portfolio and thus appeals a broad market share. This
consequently leads to superior demand either through increased number of purchases per
customer or through increased number of customers. However, this is conditional upon industry
conditions and customer preferences. Moreover, there is general consensus that when
differentiation alone is translated to increased product quality, it is insufficient as a way of
achieving low cost position. Competition from well established firms often causes firms to
consider flexibility and adaptability to market and industry changes. This view is clearly
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comparable to Karan’s (1984) where he argues that low input have the ability to successfully
achieve both high differentiation and low cost production.
Traditional researches cost leadership and differentiation leadership have significantly
contributed to the field of business strategy. Most of these researches, started in the 1970s were
followed by a large number of pragmatic contributions most notably in the 1980s. Before the
formal documentation of the concept of strategic positioning, researches held the view that no
two identical strategic settings ever occur. Thus researches in the field of business level strategy
were complicated to study. In light of this, the introduction of the term strategic groups marked a
significant step in the process of facilitating research.
The basic principle here is that by assigning businesses which employ similar or closely related
strategies to one strategic group, the fast array of combinations is reduced. This means that if
researchers can be able to identify businesses with distinct and recurring patterns of strategic
behaviour, they can be able to limit their arduous researches to only observing a number of
different combinations that is equal to the number identified using strategic grouping. Strategy
types, according to Porter, (1980) have been identified in several industries in consumer and
industry products, insurance, chemical as well as brewing industries.
2.5 Examining the convergence point
According to Saloner, et al, (2001) reconciliation between cost leadership strategies and
differentiation is possible. A trade-off between the two strategies exist and occurs more often but
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is not necessarily inevitable, in spite the fact that reconciliation of the two strategies is a really
enormous challenge in respect of managing process requirements and conditions that are unique
to respective strategies. Successful combination of strategies entails creative selection and
identification of all possible parameters that are consequential as to the success of each strategy.
Normally, business firms that seek to reduce trade-offs are market oriented. But in Porter,
(1980) all firms have the potential to simultaneously combine cost leadership and differentiation
but then combining of the two strategies may require an extensive experience as well as thorough
knowledge of the working of all functionalities such as procuring inputs, stocking,
manufacturing, marketing, distribution or even recruitment and training of new employees. Most
important is the fact that business firms must at all times adapt to and successfully subscribe to
new management requirements that may emerge as result of reconciling cost leadership and
differentiation strategies.
Reitsperger, (1984) in his contrary view advocates for an inevitable trade-off and says that low
cost leadership and differentiation can be reconcilable; in essence, low cost leadership can be
employed to make a differentiation strategy. This view is supported by Dell who argues that cost
leadership and differentiation remain to be essentially different competitive strategic choices. To
meet the increased competition from rivals firms must consider employing certain aspects of
both strategies. Reducing costrategies has the impact of increasing profit margin. Integrating too
many elements of low cost leadership into the differentiation strategy may well damage the
initial strategy.
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The conditions that favor low cost leadership are independent of conditions which favor
differentiation strategy and for that matter there is no priori reason to rule out possibilities of
reconciling them based on external conditions (Saloner, et al, 2004). On the contrary, external
conditions do favor mixed strategies so long as the differentiation strategy serves as a means for
expanding market share. When there is a positive correlation between market share and
differentiation, differentiation can easily generate economies of scale which in turn means that
cost reductions higher cost reduction are achieved at the same time. For that reason, both
strategies if employed well can result into massive improvement of business performance as
determined by such indices as increased profit and demand.
Researches have shown that strategies can be reconciled successfully without need for trade-off
if firms develop skills for pursuing both strategies simultaneously. In essence, a business that
combines both strategies is less vulnerable to any risk that is associated with specialization or
pure strategies. (Saloner, et al, 2004) explains that strategic specialization can result in serious
weaknesses in product offering and this may make it easy for rivals to take over the competitive
advantage. For instance, Caterpillar Corporation attempted to become the world’s highest
producer of earth moving equipment by focusing on precision and durability but failed to take
into account economies of scale. In the long-run, the strategy failed.
Businesses do not have to focus exclusively on one strategy as these risks reducing adaptability
and resilience. Combining of low cost leadership and differentiation strategies has the effect of
enhancing flexibility and thus makes it easier for businesses to adapt to all sorts of changes like
advances in technology or industry based changes. While low cost leadership on its own can
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enhance profitability by enhancing demand, it may not enable the business to achieve its
strategic business objectives if the industry is dominated by stiff competition. Thus, a
fundamental trade-off between differentiation and cost leadership is necessary.
2.6 Low cost leadership strategy
The theme stipulating through the entire overall cost leadership strategy and the objective is the
low cost relative to competitors. This is clearly overall firm’s cost leadership. Aggressive design
and construction of efficient scale facilities and active pursuit of cost reductions through
experience, tight cost and overhead control, avoidance of marginal customer accounts, and
reduction in areas like research and development, service, sale force, advertising, etc, will attain
cost leadership. Low cost relative to competitors is the main agenda running through the whole
strategy when attempting to achieve an overall cost leadership position.
It is necessary to identify the gains of low-cost position in order to understand how overall cost
leadership strategy may produce superior profitability. As suggested by Porter [a low- cost
position] offers an industry a defense against rivalry from competitors, since its lower cost
suggest strategies that it can still gain returns after its competitors have fully exhausted their
profits through rivalry. A low-cost position protects the firm from influential buyers because they
can exert influence, only to push down prices to the level of next efficient competitor.
Low cost, by providing more flexibility to cope with input cost increases, acts as a defense
against powerful suppliers. In terms of scale economies or cost advantages the factors that lead to
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low-cost position also provide necessary entry barriers. A low cost position often places the firm
in a suitable position vis-à-vis substitutes relative to its competitors in the industry Achieving a
low overall cost position frequently requires a high relative market share because scale
economies and cost advantages tend to guard a firm from powerful buyers and suppliers and
provide substantial entry handles. Put in a different manner, by reducing the five threats of
entry, that is; rivalry, substitutes, suppliers and buyers, cost advantages can create value for a
firm.
Business competitors cannot easily copy the strategy when a firm creates a sustainable cost
advantage .Sources of cost superiority that tend to be difficult to imitate include: differential
access to cost productive inputs and technological software .If, learning economics and
technological hardware is proprietary, duplication may be difficult. Particular consideration to
the organizing structure, management controls, compensation policies, and leadership strategies
must be put in place while organizing a cost leadership strategy. The arrangement of the
organization and implementation tools should comply and reinforce the strategy. Porter (1980)
has divided necessities of overall cost leadership strategy into; commonly required skills and
resources; and common organizational requirements.
Commonly necessary skills and resources when executing cost overall leadership are available
capital investments and availability of capital, process engineering skills, intense supervision of
labour, ease designed products for manufacture , and low-cost distribution systems .Common
organizational necessities constitute of serious cost control, frequent detailed control reports
structured organization and responsibilities, and incentives structured to meet strict quantitative
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objectives. According to Berney & Hesterly (2006), limited layers in the reporting structure,
easy reporting relationships minimal corporate staff, and focus on thin range of business
functions are properties of organizational structure that authorize firms to achieve the full
portencial of cost leadership strategies. Management control systems that reinforce the
implantation of cost leadership are, strict cost control systems, quantitative cost goals, direct
supervision of labour, raw materials, inventory a cost leadership philosophy. Rewards for cost
reduction and incentives for employees to be involved in cost reductions are good examples of
good compensation policies.
2.7 Product Differentiation and how it can be a source of strategic advantage
Differentiation entails differentiating the product or service provided by the firm. In other words,
it’s the creation of a product that is perceived industrial-wise to be unique .Differentiation can be
attained in various ways, for example, through design, name of the brand, brand image,
technological features, customer delivery, and dealer network. Structures of differentiation can
be sorted into three categories .To induce differentiation, affirm may target directly on product
[or service] attributes, e.g., features of a product, complexity of the product, launching of the
product,or location .A firm may emphasis on the relationship between itself and its
customers ,e.g., by customizing the product ,consumer marketing and product reputation
(Saloner, et al, 2004).
Lastly, differentiation can be applied by focusing on the linkage within or between firms, which
considers linkage within functions of a firm, linkage within other firms product composition,
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distribution channels and service support .To be ideal the firm must differentiate itself along
several dimensions. As a matter of fact, Barney & Hesterly (2006) argue that, product
differentiation is entirely an expression of creativity and innovations of individuals and groups
within the firm .It is only hindered by the opportunities at hand, or that can be generated, in a
particular industry, and by the willingness and capability of the firm to creatively explore ways
and means to take advantage of the opportunities.
Porter (1980), argues differentiation can produce super profits for the reason that, [it] provides
cover against competitive rivalry because of loyalty to the brand by customers and the resultant
price sensitivity. It also enhances the margin which helps in avoidance of low-cost position .The
expected customer loyalty and the need for a competitor to overcome uniqueness produce entry
barriers. Differentiation provides higher margins with which to counter with supplier power, and
it clearly adjust strategies to buyer power because buyers lack comparable alternatives and are
therefore price sensitive .Finally, differentiated firms in order to achieve customer loyalty must
be better positioned vis-à-vis substitutes than its competitors.
Apart from reducing the threat of the five such as entry, rivalry, substitutes, suppliers and buyers,
differentiation adds value by facilitating a firm charge a premium price that is greater than the
marginal cost incurred by differentiation. Successful differentiation requires that the strategy be
rare, scarce and costly to duplicate. And scarce , rare and costly structures for differentiation are
sources of sustainable competitive advantage .As stated earlier, Barney & Hesterly (2006) mean”
the rarity of a differentiation move depends on the ability of individual firms to be innovative
and creative in finding new ways to differentiate their products”. In other words, innovative and
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creative firms will always manage to differentiate themselves from competitors .As rivals move
in to imitate these firms’ last differentiation move, innovative and creative firms will already be
working on new moves thus they will be one step ahead of competition.
In general, bases and structures for differentiation that are costly to imitate and duplicate include,
between functions timing location reputation distribution channels and services, and
support .Depending on the circumstances, product contents, with other firms ,product
customerisation and complexity, and consumer marketing could be costly to imitate or duplicate.
Preparations to launch a differentiation strategy need particular consideration to the
organizational structure, management controls, compensation policies, and implementing cost
leadership strategies. Mentioned earlier, organization and implementation tools must fit and also
reinforce the strategy. According to Porter (1980) the commonly required skills and resources for
initiating differentiation are; strong marketing abilities, product engineering, creative and
innovative flair, basic research strong capability, corporate reputation for quality or technological
leadership, long industrial tradition or unique and rare combination of skills taken from other
businesses, and strong cooperation from reliable channels.
Strong coordination among functions in the functions of product development and marketing,
subjective measurement and incentives (instead of quantitative measures), and amenities to pull
professional and highly skilled labor, scientist strategies or innovative and creative people, are
the common organizational requirements. In addition Barney & Hesterley (2006) suggested that,
an organizational structure in support of differentiation may be characterized by cross-divisional
and cross-functional development teams, complex matrix structures and scattered pockets of
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intense creative efforts (skunk works) Typical management control systems that support
differentiation are broad management - making guidelines, managerial freedom within
guidelines and policy of experimentation. An example of compensation policy that supports
differentiation is rewarding risk-taking (as opposed to failure), creativity and multi dimensional
performance. Contrary to overall cost leadership, differentiation can become a hindrance to high
market share. This is because differentiation typically demands a perception of exclusivity with
high market shares.
CHAPTER THREE: RESEARCH METHODOLOGY
3.1 Introduction
This section spells out the procedures and the methods that the researcher employed in achieving
the objectives of the project as highlighted in the abstract of this paper. It defines the location of
the study, research procedures and analysis plan that were addressed in the course of the study
consideration when carrying out this particular research. The research was supposed to start with
the clear understanding of the research objectives as well as the hypothesis. Success of the
project was a factor of the provision of satisfying information in line with the objectives and
hypothesis relation to the fundamental trade-off between cost leadership and differentiation
strategies
3.2 Research Design
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The main objective of this research just as a recap is to identify the current state of the art trade-
off between low cost leadership and differentiation strategies in theory. The theoretical findings
of this research are complemented by several practical observations of the fundamental trade-off
drawn from several practitioners who have successfully reconciled the two strategies. In order to
fully satisfy the stated purpose of the research, the research has offered to conduct an analytical
and critical literature review of the subject. The reason for this is that the only way in which a
thorough analysis and understanding of the current state of the art of the topic can be understood
is by evaluating its current literature and examining its application in businesses.
A partial review of the literature can produce an erroneous image of the current state of the art of
the topic and as such, the researcher has undertaken a review of all major literature on the topic.
Having taken this important consideration into account, the researcher sees literature review
coming forth as a foreseeable as well as inevitable method. As Phillips et al, (1983) note,
when research on a topic is still nascent and knowledge relatively scarce, exploratory methods
like literature review become appropriate in conducting researches. The other decision underlies
the choice of data collection method. In any research study, there are two alternatives, namely
qualitative and quantitative data collection. The quantitative approach focuses on reasons and
facts. The primary objective of this approach is to identify and explain casual relationships
between phenomenons and as such the requirements on quantification of concepts and
objectivity of results are very high. The qualitative approach on the other hand is only applied
when one aims to uncover and understand phenomenon of which little or nothing is known
about. In contrast to the research method decision where the choice was quite evident, choice of
data collection is very complicated.
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Both qualitative and quantitative approaches can serve to collect data but the researcher adopted
the qualitative approach for the simple reason that this approach provides a complete image of
the topic under consideration besides offering a deeper insight into the issue of trade-off. By
disclosing all underlying arguments in respect of the trade-off issue, the evidences and examples
presented in the literature review makes a vivid reflection of the up to date debate on the topic.
This way, the readers will gain a better understanding and enhanced insight of the topic. In
addition, the approach will allow the reader to analyze and criticize all the arguments that have
been put forth. However, one main disadvantage of the qualitative approach is that it is not able
to provide a quantifiable answer at to which method or school of thought holds.
3.3 Data collection
The literature review section which makes the main contributor of this dissertation maps the
existing literature base so as to frame the problem in perspective and determine how the topic is
handled by current researchers. By reflecting on the nature the main debate, the topic has been
placed in an historical context which also reveals potential familiarity with current developments
in respect of the issue of trade-off.
Secondary data which mainly consists of strategies of various types of literature has been utilized
greatly in the development of the literature review and was in particular derived from journals,
strategic textbooks, online journals and reviews. The greatest advantage of secondary data is that
it is relatively easy and cheap to access and requires a very simple process to verify the
26
information. The only inconvenience which is common in literature review is that all underlying
concepts as well as definitions, variable measurement and unit determination can at times differ
which if the case can have negative effects on the validity of results.
3.4 Research validity and reliability
The objective of this research is to establish accurate findings and yet the results and findings of
any report can only be accurate in light of the measure thus it is critical to evaluate the
effectiveness of the measure. In this section, particular attention is paid to validity and reliability.
These two values are critical to ensuring the scientific value of a research by asserting that
research findings are appropriate and useful. Validity determines how truthful findings are, that
is how well the research findings reflect the reality.
Three different types of validity can be distinguished namely, construct validity, external validity
and internal validity. Internal validity refers to the extent to which the research can permit
conclusions to be drawn that there is a casual relationship between two or more variables.
Construct validity and external validity on the other hand refer to how operationalization
measures the concept which it purports to measure. This is a very important aspect of research
quality that because it sets condition for interpretable and meaningful findings.
A debate about the findings of the preceding literatures on the fundamental trade-off between
low-cost leadership and differentiation includes the discussion of the ‘research’, more often than
not referring to the manner in which the statistics were collected”. This research being a
phenomenological, all questions are related to theoretical characteristics discussed in literature
27
preview. The process would therefore be accurate in collecting, analyzing and sampling data;
hence the validity of result would be quite high. Considering that there are many different
aspects of validity, which influence the validity of the research in general.
3.5 Limitations
This dissertation does not seek to explore all existing literature on the topic. In stead, the research
has been conducted as a pre-work and is as such insufficient to fulfill the requirements of
literature review. The objective is to provide a critical and analytic evaluation of the problem
under study as identified in the previous section by reviewing the existing literature. Most
important is the fact that it is important to make a distinction between the various strategy levels.
Therefore, in the scope of this dissertation, the broad concept of strategy is limited only to
business level strategy. This limitation has been necessitated by the purpose of the research as
highlighted in the previous section and forms the guidance upon which the task is undertaken.
CHAPTER FOUR: DISCUSSION OF RESEARCH FINDINGS
4.1 The fundamental Trade-off between cost leadership and differentiation
Porter states that three conditions explain a firm’s success .One, a company must develop an
internally set of consistent set of objectives and functional policies that, that as a while define its
position in the market. To be more specific, strategy is perceived as a way of integrating the
activities of the diverse functional departments within a firm, marketing, production, research
28
and procurement, finance and the like. An in-depth, explicit and mutually reinforcing set of goals
and functional policies are required to counter the centrifugal forces that lead functional
departments in various directions .Two, another condition for success is the internally consistent
set of goals and policies aligning the firm`s strengths and weaknesses with the (external) industry
opportunities and threats.
Strategy is the act of setting a company in line with its environment .Three, a firm’s strategy
must be in line with the creation and explosion of its so called ‘distinctive competences’. Choice
is essential, although there is no one way to position, on the contrary, there may be several
attractive positions .The challenges facing a firm in choosing a distinct position from its
competitors in order to avoid replication-a threat competitive advantage-while considering
logical inconsistencies in pursuit of several of several types of advantage or different aims
simultaneously .The general strategies advanced by Porter (1980) satisfy these conditions.
Even though Porter did not conjure the terms, cost leadership and differentiation, he was the first
to discuss the importance of selecting and focusing on one of the alternatives. Firms that do not
develop strategies in at least one of the three directions are called ”stuck in the middle”, a poor
strategic situation that yields low profits: “[the firm stuck in the middle]” either loses high
volume of customers who demand for low prices or must bid away its profits to get the business
away from low-cost firms. It also loses high-margin businesses-the cream to the firms that are
high-margin targets or have achieved differentiation overall (Saloner, et al, 2004).
29
Market-leading firms inside overall cost leadership are the largest, while differentiation or focus
strategy are the smallest .Stuck in between are the least profitable firms or medium sized. In
effect Porter argues that strategies can be successfully reconciled under serious circumstances;
effectively laying down any of these generic strategies demands total commitment and
supporting organizational arrangements that are diluted if more than one primary target exist
strategies and hence it becomes necessary for a firm to select and adopt one of the three
suggested generic strategies.
4.2 Realization of the benefits of strategic business planning
Porter is considered by many as the most authoritative strategist in the in business strategy.
Phillips et al, (1983) for instance reckons that the arguments underlying the concepts advocated
in porter’s model of competitive strategy have shaped much f the present thinking in the
formulation of strategy. In essence, Porter’s model has been widely tested and in spite of several
efforts to modify or expand it, its original model has to date remained the most widely
commented, analyzed and tested. This model has been applauded for being easy to understand
appropriately without being vague.
Thus, an explicit method for formulating policies should be used to determine a business firm’s
long run competitive strength. This can help in generating a persistently higher rate of profit than
its competitors. In order to compete effectively in the long run, a first must start its operations by
choosing an appropriate positioning. Porter in his model proposed three different approaches for
gaining competitive advantage namely overall cost leadership, differentiation and focus.
30
At around the end of the 1980s and the beginning of the following decade, there were debates
about whether the two strategies are mutually exclusive but these debates seem to have died
gradually with the introduction of the Japanese twin cost control methods, namely Total Quality
Management and Just In Time models, (Saloner, et al, 2001). These two models were widely
applied by major Japanese companies and were responsible for the success of such industries as
electronics, motorcycles, cars and musical instruments which have benefited massively from
their ability to combine low cost leadership with high quality and technological advancement.
The three strategies above have the capability of resulting in above- average profits; but all the
three may not be suitable for a firm. They may not be suitable because the three strategies are
different on several aspects and posses different requirements. This is identified in resources,
skills organizational arrangements, control procedures, incentive systems and management style.
Depending on how the selected strategy is applied, profitability may vary this is what will decide
on which strategy to adopt keeping in mind the benefits of strategic planning that dictate that the
selection be well founded.
The test and challenge comes in the selection of the best strategy that suits the firm’s strengths
and recourses and cannot be easily copied by competitors. This, on the other hand, demands for
good knowledge about the firm, its business surrounding and competitors. If the practitioner is in
possession of an explicit technique to analyze the firm’s structure and competition, there will be
gains in getting better knowledge and understanding of both elements. Porter’s (1980) model
31
enables the decision making strategy and enhances the profits of a firm that selects a suitable
strategy.
4.3 Cost leadership-differentiation trade-off
The major reason why Porter and his followers of this theory advocate that a combination
strategy is a low strategic choice is that conflicting organizational requirements of cost
leadership and differentiation strategies create a trade-off that is necessary .The challenge is also
very costly and complicated, it is argued. Critics of Porter`s theory trust that a trade-off does not
have to be there .The main argument of the opposing school of thought is that differentiation
may be a product of cost reduction (scale and learning economies, innovation processes),which
means that factors that favor differentiation and coast leadership are not incompatible (Saloner,
et al, 2004).
Thus, as long as differentiation leads to cost reductions or enhanced price premium or both, cost
leadership and differentiation strategies can be mixed without a trade-off. The literature
references have shown several explanations as to why differentiation may reduce costs. Further
more, firms can develop management skills to relate with cost leadership and differentiation
strategy requirements, it is argued .There is prove by the empirical studies that have observed the
operation of firms with mixed strategies and the observations that have measured performance of
strategies and concluded that, firms having mixed strategies do equally good or better than cost
leaders and differentiators.
32
Nearly two thirds of the empirical study within the located literature lay their support on the
argument in preference of reconcilable strategies .In other words, by measuring the identified
literature on the subject, a good number of the research follows the opposing school of
thought .In relation to interviewed practitioners, three for every four suggested that a trade-off
need not be and hence, results from the interviews look consistent with results from the literature
review. Also the literature review has shown that there are two major elements determining
whether researchers follow to Porter`s school of thought or the opposing school: the
conceptualization of cost leadership and differentiation, and the opinion on the nature of the
correlation between market share and performance (Saloner, et al, 2004).
To begin with, the conceptualization of cost leadership and differentiation as two dimensions of
strategic placing rather than two types of strategies permits researchers to discover the existence
of “combination” strategies. By looking at the two strategies as opposite ends of a single
continuum or two unrelated types of wide strategic groups, researchers overrule the possibility of
reconciling strategies for, closer to one end automatically means moving father away from
another. Selecting to position between the two ends is the same to choosing a stuck in the middle
strategic. The second supporters of a correct relationship between market share and performance
also state that cost leadership and differentiation strategies may move together as differentiation
is a source of cost reduction .Those who answered on the cross-check on the topic stated that
differentiation will serve to achieve cost reduction and that the relationship between
differentiation strategy and market share will be correct (although it is not necessarily the case).
33
Anyway, not all respondents accept that this potentially responsive relationship means that
strategies will be reconciled. It’s true, a cost reduction need not require a serious change in
strategy as explained by Stefan Viotti and the case of SAS and snowflake.
In relation to method, cluster analysis techniques as a way to express strategic groups and the use
of the PIMS database for gathering samples dominates the sampled research studies. This was
also looked into by Campbell-Hunt (2000).
The literature review has tried to locate, present and summarize the available research of the
subject so as to make it clear what is being argued in and differentiation. Selected literature has
been classified in relation to school of thought, meaning whether strategies are trusted to be
mutually exclusive or can be potentially combined. Yet an important element to the discussion is
the meaning of the concept “combination strategy” (or “mixed” or “combined” strategy).
Although it is assumed that, a combined strategy has both elements usually associated with cost
leadership and with differentiation strategy, the definition remains unclear and allows a range of
interpretations. Often, It is emphasized that the two strategies must be applied simultaneously,
White (1986)alternatively advocates that firms can externally lay emphasis on opportunities to
differentiate while internally focused towards cost reduction; mixed strategies is arrived at
through the” sequential instead of simultaneous focus to the different organizational
requirements of these diverse business strategies.
As observed, the definition of “mixed strategy” or “combined strategy” can influence the
working together with either of the two schools of thought, and hence the lack of a stable, clear
34
and definite definition renders research on the subject a tough affair. It’s difficult to compare
studies and the accumulated load of evidence is not available. The difficulty with a lacking
concrete definition can be seen in the literature. In some particular cases, a company is portrayed
as a successful cost leader of differentiator by a researcher, as others refer to the same as prove
that a trade-off may be avoided.
This is the issue with Wal-Mart:While Barney & Hesterley (2006) and Lumpkin, Droege & Dess
(2002) describe Wal-Mart successfully adopts a combined strategy and hence evidences the truth
that a trade-off may be done away with. The issue of Southwest brings out a another related
example as several researchers state that the airline is employing a cost leadership strategy,
e.g .Lumpkin, Droege & Dess (2002),with others arguing that the strategy employed is a mix of
cost and leadership differentiation, e.g. Grant (2006).Although Porter`s definitions and theories
is based on their studies, these researchers have advocated distinguishing observations and
discussions which explain that there is adequate space for (mis) interpretation.
Ghemawat refers to MacDonalds as facts that firms can realize ways to generate superior
products at lower costs, stating that ”McDonald`s brand recognition and product superiority at
lower cost explains that ”McDonald`s brand recognition and product consistency permit it to
charge a small premium over challenging fast-food vendor, even if it`s broad scale ,franchising
relationships and serious standardization permitted it to experience lower costs than it’s
competitors. After all, establishing ways to create a superior product at less cost is enough to
present a mixed strategy.
35
Conclusion
As shown by the definitions of cost leadership and differentiation depicted in the Theory section
of this presentation, a firm must identify its strategy which is scarce, rare and costly to copy if it
wishes to produce competitive advantage and superior profitability. A leader in market cost
(Saloner, et al, 2004). For example, is not the firm that particularly sells at the extreme lowest
cost? As observed earlier a strategy is composed of many elements and especially; total elements
and specifically the way they relate is what brings out the strategy. By designing its brand
recognition and product consistency, McDonald was capable of charging a premium and in turn
to outwit its rivals, as Porter`s theory expects. Hence, due to a remarkably successful cost
leadership strategy, McDonald`s resulted as the cost leader per (Porter`s) definition.
36
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