# Business-Level Strategy - Principles of Management

To build a sustainable competitive advantage managers need a good grasp of business-level strategy. A firm’s business-level strategy is the basic theme that a company emphasizes to compete effectively with rivals in an industry. A firm’s business-level strategy encompasses three related choices: the competitive theme that managers emphasize, how to segment the market within an industry, and which segments to serve.

COMPETITIVE THEME: DIFFERENTIATION OR LOW COST?

Basic business-level strategy is concerned with making the choice between low cost and differentiation. We have already noted that these are two distinct ways of gaining a competitive advantage. So basic are these two strategic orientations that Michael Porter, who wrote one of the classic books on competitive strategy, has referred to them as “generic strategies.”

Low-Cost Strategy A low-cost strategy is concerned with giving consumers value for money and focusing managerial energy and attention on doing everything possible to lower the costs of the organization. Wal-Mart, Dell Inc., and Southwest Airlines are all examples of firms that have pursued a low-cost strategy. All three enterprises focus on offering basic goods and services at a reasonable price, and they try to produce those goods and services as efficiently as possible.

Thus Wal-Mart’s stores have minimal fixtures and fittings, are self-service rather than full-service, and sell merchandise at a discounted price. Unlike its rivals, Dell does not invest heavily in R&D to produce leading-edge computers. Rather, it sells good machines at a discounted price. Similarly, Southwest Airlines provides its customers with minimal inflight service in an attempt to lower costs and thus support inexpensive ticket prices.

The successful pursuit of a low-cost strategy lets a firm charge less than its rivals and still make profits. Moreover, firms that charge lower prices might also be able to gain market share—as Dell, Wal-Mart, and Southwest Airlines have all done—which allows them to realize economies of scale (cost advantages derived from a large sales volume) and reap further cost reductions. Thus firms that successfully pursue a low-cost strategy can set up a value cycle similar to that illustrated in Figure, which lets them consolidate their cost advantage over time.

Differentiation Strategy A differentiation strategy is concerned with increasing the value of a product offering in the eyes of consumers. A product can be differentiated by superior reliability(it breaks down less often or not at all), better design, superior functions and features, better point-of-sale service, better after-sales service and support, better branding, and so on.

Thus a Rolex watch is differentiated from a Timex watch by superior design, functions, features, and reliability; a Toyota car is differentiated from a General Motors car by superior reliability (new Toyota cars have fewer defects than new GM cars); Nordstrom differentiates itself from Wal-Mart by the quality of its products (such as Armani suits), numerous in-store sales personnel that can help even the most fashion-challenged individual dress well, and a store design that creates a luxurious shopping atmosphere.

If consumers value a differentiated product offering over that sold by rivals, a differentiation strategy will give the firm a competitive advantage so it can capture more consumer demand. For example, Starbucks has successfully differentiated its product offering from that of rivals such as Tully’s by the excellent quality of its coffee-based drinks; the quick, efficient, and friendly service its baristas offer customers; the comfortable atmosphere created by the design of its stores; and its strong brand image. This differentiation has given Starbucks more of the market for coffee-based drinks.

Having differentiated their product, the issue facing managers is how best to translate the competitive advantage that comes from successful differentiation into sustained high profitability and profit growth. Complicating the issue is the fact that differentiation often (but not always) raises the cost structure of the firm. It costs Starbucks quite a lot, for example, to purchase, roast, and brew premium coffee, to train its baristas, and to furnish its stores.

One option managers have is to raise prices to reflect the differentiated nature of the product offering and cover any increase in costs. This is an option that many pursue. It can by itself enhance profitability so long as prices increase more than costs. For example, the Four Seasons chain has luxurious hotels. It costs a lot to provide that luxury, but Four Seasons also chargeshigh prices for its rooms, and the firm is profitable as a result.

However, greater profitability and profit growth can also come from the increased demand associated with successful differentiation, which allows the firm to use its assets more efficiently and thereby simultaneously realize lower costs from scale economies.

This leads to another option: The successful differentiator can also hold prices constant (or increase prices only slightly), sell more, and boost profitability through scale economies . Thus successful differentiation by Starbucks raises the volume of traffic in each Starbucks store, thereby increasing the productivity of employees in the store (they are always busy) and the productivity of the capital invested in the store itself.

So each store realizes scale economies from greater volume, which lowers the average costs at each store. Spread that across the 6,000 stores that Starbucks operates, and you have potentially huge cost savings that translate into higher profitability. Add this to the enhanced demand that comes from successful differentiation, which in the case of Starbucks enables the firm not only to sell more from each store but also to open more stores, and profit growth will also accelerate.

SEGMENTING THE MARKET

Markets are characterized by different types of consumers. Some are wealthy, some are not; some are old, some are young; some are influenced by popular culture, some never watch TV;some care deeply about status symbols, other do not; some place a high value on luxury, some on value for money. Markets can be segmented by a variety of factors, common examples being the income, demographics, preferences, and tastes of consumers.

Moreover, different enterprises can segment the same market in different ways, and various approaches might be reasonable. Take the retail market for apparel: Wal-Mart’s clothing department targets lower income, value-conscious consumers looking for basic clothing; Chico’s targets value conscious, middle-income and middle-aged women with an eye for fashion; Abercrombie &Fitch targets the casual fashion-conscious youth market; Brooks Brothers targets middle- and upper-income male business executives with a taste for stylish formal business attire; Eddie Bauer targets middle- and upper-income consumers who are looking for stylish casual clothing with an outdoor theme; Victoria’s Secret targets…well, never mind! These different approaches all represent different ways of segmenting the market—by value preferences, income, age, tastes, and so on.

There is no single best way of segmenting a market; but in terms of attaining a competitive advantage, some approaches to segmentation make more sense. At a minimum, a segment must have enough demand to be served profitably. There are no apparel retailers, for example, who target a segment consisting of sedentary old white males who like to dress in the baggy athletic clothing favored by rap musicians; there are not enough potential consumers in that segment to make it profitable to serve.

Beyond this commonsense notion, there may be value in segmenting the market in a unique way that distinguishes the firm from rivals. Costco, the fast-growing discount warehouse store, targets relatively affluent value-conscious consumers. We tend to think of warehouse stores as offering merchandise at a deep discount from normal prices (they are pursuing a low-cost strategy).

Costco indeed does that; but the merchandise the firm sells can be high-end, from Polo brand shirts that would normally retail for $70, which Costco might offer for$40, to $40,000 diamond rings that Costco sells for$25,000. As one Costco executive told this author, “We can offer Polo shirts at a deep discount and our customer will recognize the value and snap them up, buying 10 at a time.

Wal-Mart could do the same thing, and their customers wouldn’t recognize the value, and they would not be able to sell them.” Costco attracts a different type of customer because it has segmented the market differently than Wal-Mart. Costco’s product offering reflects its managers’ decisions about how best to segment the market.

Generalizing from the Costco example, segmenting the market in a unique but economicallyviable way can be a good starting point in the quest to build a sustainable competitiveadvantage. It is not necessary to segment the market uniquely, however. Toyota has segmented the automobile market conventionally (according to income and age), but it still has a competitive advantage. When segmenting the market, managers must have a clear idea of the consumers they are trying to serve, what the needs of those consumers are, and how the business is going to serve those needs.

CHOOSING SEGMENTS TO SERVE

Having decided how to segment the market, managers must decide which segments to serve. Some enterprises focus on a few segments or just one. Others serve a broad range of segments. In the automobile industry, Toyota has brands that address the entire market: Scion for budget-constrained, young, entry-level buyers; Toyota for the middle market; and Lexus for the luxury end of the market.

In each of these segments Toyota pursues a differentiation strategy; it tries to differentiate itself from rivals in the segment by the excellent reliability and high perceived quality of its offerings. In contrast, Porsche focuses exclusively on the top of the market, targeting wealthy middle-aged male consumers who have a passion for the speed, power, and engineering excellence associated with its range of sports cars.

Porsche is clearly pursuing a differentiation strategy with regard to these segments, although it emphasizes a different type of differentiation than Toyota. When managers decide to serve a limited number of segments, or just one segment, we say that they are pursuing a focus strategy. When they decide to serve the entire market, they are pursuing a broad market strategy.

SEGMENTATION AND STRATEGY

We have suggested that there are three dimensions to business-level strategy: the competitive theme managers emphasize (low cost or differentiation), the way they choose to segment the market, and the segments they serve. Taken together, these dimensions allow a variety of different ways to compete in an industry. Figure summarizes two of these dimensions— competitive theme and segments served. Also included in Figure are some illustrative examples chosen from the U.S. retail industry.

Broad low-cost and broad differentiation strategies aim to serve many segments in an industry and strive for either a low-cost or a differentiated position. Focused low-cost and focused differentiation strategies focus on one or a few specific segments and strive to attain a low-cost or differentiation position relative to that segment. However, Figure 6.5 does not capture the full richness of business-level strategy.

Various businesses may segment themarket differently and focus on disparate segments. Although Costco and Dollar Tree areboth shown as focused low-cost businesses in the retail industry, they compete in verydifferent spaces. All of the merchandise in a Dollar Tree store is priced at a dollar or less.

Dollar Tree sells a lot of small household items at deep discounts to low-income consumers. In contrast, as already noted, Costco sells higher-end items at a deep discount to middle- and high-income value-conscious consumers. Costco customers do not usually enter Dollar Tree stores and vice versa.

THE LOW COST–DIFFERENTIATION FRONTIER

So far we have suggested that low-cost positions and differentiated positions are two different ways of gaining competitive advantage. The enterprise that is striving for the lowest costs does everything it can to cut costs out of its operations, whereas the enterprise striving for differentiation necessarily has to bear higher costs to achieve that differentiation. Put simply, a firm cannot simultaneously be Wal-Mart and Nordstrom, Porsche and Kia, or Rolex and Timex. Managers must choose between these basic ways of attaining competitive advantage.

However, presenting the choice between differentiation and low costs in these terms is something of a simplification. In practice, the strategic issue facing managers is what position to choose on a continuum that is anchored at one end by very low costs and at the other by a very high level of differentiation. To understand this issue, look at Figure. Its convex curve illustrates what is known as an efficiency frontier.

The efficiency frontier shows all the different positions a firm can adopt with regard to differentiation and low cost assuming that its internal operations are configured efficiently to support a particular position. (Note that the horizontal axis in Figure is reverse scaled—moving along the axis to the right implies lower costs.) For an enterprise to reach the efficiency frontier—to have a competitive advantage and achieve superior performance—it must have unique strengths or distinctive competencies that rivals inside the frontier lack and that enable it to operate efficiently.

The efficiency frontier has a convex shape because of diminishing returns: When a firm already has significant differentiation built into its product offering, increasing differentiation by a relatively small amount requires significant additional costs. The converse also holds: When a firm already has a low cost structure, it has to give up a lot of differentiation in its product offering to get additional cost reductions.

The efficiency frontier shown in Figure is for the U.S. retail apparel business(Wal-Mart sells more than apparel, but that need not concern us here). As you can see,Nordstrom and Wal-Mart are both shown on the frontier, implying that both organizations have configured their internal operations efficiently. However, they have adopted different strategic positions. Nordstrom has high differentiation and high costs (it is pursuing a differentiation strategy), whereas Wal-Mart has low costs and low differentiation (it is pursuing a low-cost strategy).

These are not the only viable positions in the industry. We have also shown Abercrombie & Fitch on the frontier. Abercrombie & Fitch offers higher quality apparel than Wal-Mart, sold in a more appealing store format; but its offering is nowhere near as differentiated as that of Nordstrom, and it is positioned between Wal-Mart and Nordstrom. This midlevel position, offering moderate differentiation at a higher cost than Wal-Mart, makes sense because there is a large enough segment of consumers that demand this kind of offering.

Often multiple positions on the low cost–differentiation continuum are viable in the sense that they have enough demand to support an offering. The strategic task for managers is to identify a viable position in the industry and then configure the enterprise’s internal operations as efficiently as possible, to enable the firm to reach the frontier. Not all firms can do this. Only firms that can get to the frontier have a competitive advantage.

Not all positions on an industry’s efficiency frontier are equally as attractive. At some positions there may not be sufficient demand to support a product offering. At other positions too many competitors may be going after the same consumers (the competitive space might be too crowded), and the resulting competition might drive prices down below levels that are acceptable.

In Figure Kmart is shown inside the frontier. Kmart is trying to position itself in the same space as Wal-Mart, but its internal operations are not efficient. Indeed, the company was operating under bankruptcy protection in the early 2000s (it is now out of bankruptcy). Also shown in Figure 6.6 is the Redmond, Washington–based clothing retailer Eddie Bauer, which is owned by Spiegel. Like Kmart, Eddie Bauer is not currently run efficiently relative to its rivals, and its parent company is operating under bankruptcy protection.

Value Innovation The efficiency frontier in an industry is not static; it is continually being pushed outward by the efforts of managers to improve their firms’ performance. The companies that push out the efficiency frontier can offer more value to their customers (through enhanced differentiation) at lower cost than their rivals—a process sometimes referred to as value innovation.

Dell Computer has achieved value innovation in the personal computerindustry. In the 1980s when other computer firms were selling through retailers, Michael Dell pioneered the practice of selling direct. By the mid-1990s Dell was selling over the Internet, and today 85 percent of its home PCs are sold this way. A great advantage of this strategy for customers is that they can customize their PCs, mixing and matching components to get just what they want. Thus by adopting a direct selling business model, Dell differentiated itself from competitors, offering its customers more value.

The direct selling strategy has also had far-reaching implications for Dell’s costs. Because it sells direct, Dell can build to order. Unlike competitors, it does not have to fill a retail channel with inventory. Moreover, Dell can use the Internet to feed real-time information about order flow to its suppliers so they have up-to-the-minute information about demand trends for the components they produce, along with volume expectations for the upcoming 4–12 weeks.

Dell’s suppliers use this information to adjust their own production schedules, manufacturing just enough components for Dell’s needs and shipping them by the most appropriate mode to arrive just in time for production. Dell’s ultimate goal is to drive all inventories out of the supply chain apart from those actually in transit between suppliers and Dell, effectively replacing inventory with information.

Although it has not yet achieved this goal, it has driven down inventory to the lowest level in the industry. Dell has about two days of inventory on hand, compared to 20–30 at competitors such as Hewlett-Packard and Gateway.

This is a major source of competitive advantage in the computer industry, where component costs account for 75 percent of revenues and the value of components falls by 1 percent per week due to rapid obsolescence. Thus by pioneering online selling of PCs, and by using information systems to coordinate its supply chain, Dell Computer has attained new levels of operational efficiency.

In essence, Dell has built new distinctive competencies, and in doing so has pushed out the efficiency frontier in the personal computer industry. Dell now offers more differentiation (the ability to customize a PC when placing an order on the Web) at lower cost than its rivals can offer.

In industry after industry this is how competition proceeds: Firms compete by developing superior competencies that enable them to push out the efficiency frontier, stranding rivals at a competitive disadvantage. It follows that a central strategic task of managers is to look for ways of improving operating efficiency and enhancing value through differentiation in order to take the enterprise to a new level of excellence.