The choice of industry affects firm performance but, within any given industry, some companies are more profitable than others. Why do some companies do better than their competitors?
A firm that formulates and implements a strategy that leads to superior performance relative to other competitors in the same industry or the industry average has a competitive advantage. The greater the performance, the greater is its competitive advantage. A sustained competitive advantage occurs when a firm maintains above-average performance for a number of years.
“When a firm sustains profits that exceed the average for its industry, the firm is said to possess a competitive advantage over its rivals. The goal of much of business strategy is to achieve a sustainable competitive advantage” (Porter, 1985)
Strategy describes the goal-directed actions a firm intends to take in its quest to gain and sustain competitive advantage. The firm that possesses competitive advantage provides superior value to customers at a competitive price or acceptable value at a lower price. Profitability and market share are the consequences of superior value creation. The important point here is that strategy is about creating superior value, while containing the cost to create it. The greater the difference between value creation and cost, the greater the economic contribution the firm makes, and thus the greater the likelihood for competitive advantage.
The key message in Michael Porter’s theory of competitive strategy is that firms must be able to create a defendable position in an industry, in order to cope successfully with competitive forces and generate a superior return on investment. According to Porter, cost leadership and differentiation are two basic strategies for creating value and attaining a competitive advantage in an industry. Competitive advantage (and higher profits) goes to those companies that can create superior value—and the way to create superior value is to drive down the cost structure of the business and/or differentiate the product in some way so that consumers value it more and are prepared to pay a premium price.
“Competitive advantage grows out of value a firm is able to create for its buyers that exceeds the firm’s cost of creating it. Value is what buyers are willing to pay, and superior value stems from offering lower prices than competitors for equivalent benefits or providing unique benefits that more than offset a higher price. There are two basic types of competitive advantage: cost leadership and differentiation.” (Porter, 1985)
Firms that pursue both strategies have a competitive advantage compared with the differentiator because they have lower production costs; they also have an advantage compared with the cost leader because they can charge a premium price. Consequently, more and more firms are pursuing both strategies simultaneously.
Internal analysis leads to the identification of a firm’s strengths and weakness, and especially its distinctive competencies, including its resources and capabilities. Distinctive competencies enable firms to create superior value for customers, by helping them to achieve the four main building blocks of competitive advantage:
- Efficiency: In a business organization, inputs such as land, capital, raw material managerial know-how and technological know-how are transformed into outputs such as products and services. Efficiency of operations enables a company to lower the cost of inputs to produce given output and to attain competitive advantage. Employee productivity is measured in terms of output per employee.
- Quality: Quality of goods and services indicates the reliability of doing the job, which the product is intended for. High quality products create a reputation and brand name, which in turn permits the company to charge higher price for the products. Higher product quality can also result in greater efficiency, with less employee time wasted fixing defective products or services. This translates into higher employee productivity, which means lower unit costs.
- Innovation: Innovation means new way of doing things. Innovation results in new knowledge, new product development structures and strategies in a company. Successful innovation gives a company something unique that its competitors lack (that is, until imitation occurs). This uniqueness allows a company to differentiate and charge a premium price. Successful innovation may also allow a company to reduce its unit costs. Studies in several industries have shown that innovation is a major driver of superior profitability.
- Responsiveness to Customers: Companies are expected to provide customers what they are exactly in need of by understanding customer needs and desires. It involves doing everything possible to identify customer needs and to satisfy those needs. Customer responsiveness is determined by customization of products, quick delivery time, quality, design and prompt after sales service.
In summary, superior efficiency enables a company to lower its costs; superior quality enables a company both to charge a higher price and to lower its costs; superior innovation can lead to higher prices or lower unit costs; and superior customer responsiveness enables a company to charge a higher price.
Building strategy-critical core competencies and competitive capabilities not easily imitated by rivals is one of the best ways to gain a competitive advantage. Core competencies emerge from skills and activities performed at different points in the value chain that, when linked, create unique organizational capability. The key to leveraging a company’s core competencies into long-term competitive advantage is to concentrate more effort and more talent than revivals competitive advantage is to concentrate more efforts and more talent than revivals of on strengthening and deepening organizational competencies and capabilities.
At the most fundamental level, firms create competitive advantage by perceiving or discovering new and better ways to compete in an industry and bringing them to market, which is ultimately an act of innovation. Innovations shift competitive advantage when rivals either fail to perceive the new way of competing or are unwilling or unable to respond. There can be significant advantages to early movers responding to innovations, particularly in industries with significant economies of scale or when customers are more concerned about switching suppliers.
Superior value creation is driven by a firm’s ability to differentiate its products or reduce its expenses. When firms are able to create superior value, they experience higher profitability. It’s also important for firms to sustain their competitive advantages over time, to maintain their competitive advantage, and to take steps to avoid competitive failure.
The sustainability of competitive advantage depends on three conditions.
- The first is the particular source of the advantage. There is a hierarchy of sources of competitive advantage in terms of sustainability. Lower-order advantages, such as low labor costs or cheap raw materials are relatively easy to imitate. Higher-order advantages, such as proprietary process technology, product differentiation, brand reputation and customer relationships are more durable. Higher-order advantages involve more advanced skills and capabilities such as specialized and highly trained personnel, internal technical capability and often close relationships with leading customers. Such advantages also demand sustained and cumulative investment in physical facilities and specialized intangible assets.
- The second determinant of sustainability is the number of distinct sources of advantage a firm possesses. If there is only one advantage, competitors can more easily nullify this advantage. Firms which sustain leadership over time, tend to proliferate advantages throughout the value chain.
- The third, and most important basis for sustainability is constant improvement and upgrading. A firm must keep creating new advantages at least as fast as competitors can replicate old ones. The firm must improve relentlessly its performance against its existing advantages. This makes it more difficult for competitors to nullify them.
In the long run, competitive advantage can be sustained only by expanding and upgrading sources and by moving up the hierarchy to more sustainable types. To sustain competitive advantage, a firm may have to destroy old advantages to create new, higher-order ones. A company must learn to exploit industry trends and close off the avenues along which competitors may attack by making pre emptive investments.
- Achieving a Sustainable Competitive Advantage
- Durability of Competitive Advantage
- Competitive Advantage of Internationalization Strategies
Short Case Study:
The global auto industry is huge, with high sales and high competitive intensity. Increasingly, automakers are working to develop a wide range of vehicles to appeal to every customer. Toyota’s lean production methods and fast time to market have aided the firm in quickly developing car models focused on different market segments. Toyota’s first effort to win the important market segment of buyers in their twenties was unsuccessful; their fuel-efficient Echo subcompact was marred by unattractive styling. The firm quickly changed its approach, introducing Matrix, with sporty hatchback styling and electronic music capability, in 2002. Toyota is also known for its ability to segment markets, such as offering six different SUV models in varying price ranges. The Japanese automaker balances the number of products against cost constraints, and it also closely monitors the actions of its competitors, especially in emerging market segments.
Hint: This case demonstrates how Toyota pursued both a low cost and a differentiation strategy, leading to an enduring competitive advantage. The case also demonstrates competitive dynamics, as Toyota was forced to adapt to changes in consumer tastes as well as the actions of competitors. In this case, Toyota was pressured to keep costs low, create unique products that competitors did not yet have, and appeal to many customer segments with diverse needs.