Question

A firm seeking cost-leadership advantage should not differentiate. Can you elaborate this as an opposition?

Answer 1

Apr. 2010, Volume 9, No.4 (Serial No.82) Chinese Business Review, ISSN 1537-1506, USA

37

A critique of Porter’s cost leadership and differentiation strategies∗

Y. Datta

(College of Business, Northern Kentucky University, Highland Heights KY 41099, USA)

Abstract: Porter identifies high market share with cost leadership, citing GM as a successful practitioner of

this strategy. However, GM became a market share leader in the American automobile industry due to a strategy

of market segmentation, differentiation and a broad scope shaped during the 1920s. Porter argues that cost

leadership and differentiation offer an equally viable path to competitive success. Nevertheless, a differentiation

strategy based on superior quality compared to competition is more profitable than cost leadership strategy. It can

lead a business to become a market share leader, and consequently even a low-cost leader. Research indicates that

differentiation and cost leadership can co-exist. However, Porter insists that each generic strategy requires a

different culture and a totally different philosophy. The problem is that Porter’s generic strategies are too broad. It

is not his logic that is flawed, but his basic premise that prescribes cost leadership strategy as the only route to

market share leadership, and presents a narrow view of differentiation with a unique product—sold at a premium

price—on the one hand, and a “standard, or no-frills” product on the other. Mintzburg (1988) says Porter’s cost

leadership strategy should be called “price differentiation”: a strategy that is based on a lower price than that of

the competition. He suggests that business strategy has two dimensions: differentiation and scope. Thus, setting

scope aside, competitive strategy has only one component: differentiation. So, the key question is not whether to

differentiate, but how? First, make customer-perceived quality as the foundation of competitive strategy because it

is far more critical to long-term success than any other factor. Second, serve the middle class by competing in the

mid-price segment, offering better quality than the competition at a somewhat higher price. It is this path that can

lead to market share leadership—a strategy that can be both profitable—and sustainable.

Key words: Michael Porter; cost leadership strategy; differentiation strategy; customer-perceived quality;

market segmentation; price-quality segmentation; outpacing strategies

1. Introduction

A scholarly work that has received widespread recognition is Porter’s (1980, 1985) typology of generic

strategies: cost leadership, differentiation and focus. These three fall into two basic categories. The focus strategy

requires concentration on a niche or a narrow segment. But, Porter says that success in this strategy can be

achieved either via cost leadership or differentiation. Thus, cost leadership and differentiation are the two basic

strategies in Porter’s typology. These two then are the subject of discussion in this paper. Here our purpose is to

offer a critique of Porter’s work, and a synthesis of the vast literature centered on it.

Thompson, Strickland, and Gamble (2008) have expanded Porter’s generic strategies from three to five.1

So,

∗

This is a revised version of a paper that was presented at the 2009 Oxford Business & Economics Conference held in Oxford,

England, June 24-26.

Y. Datta, Ph.D., professor emeritus, College of Business, Northern Kentucky University; research field: strategic management. 1

Overall low-cost provider strategy, broad differentiation strategy, best-cost provider strategy, focused low-cost strategy and focused

differentiation strategy.A critique of Porter’s cost leadership and differentiation strategies

38

the author will also briefly examine their work.2

2. Cost leadership strategy

The cost leadership strategy requires the sale of a “standard, or no-frills” product (Porter, 1985, p.13)

combined with “aggressive pricing” (Porter, 1980, p.36). Also, the firm should have a broad scope serving

multiple industry segments to gain a low cost advantage (Porter, 1985, p.12). Porter (1980, p.35) describes the

core philosophy of this strategy as follows:

“Cost leadership requires aggressive construction of efficient-scale facilities, vigorous pursuit of cost from

experience, tight cost and overhead control, avoidance of marginal customer accounts, and cost minimization in areas like

R&D, service, sales force, advertising, and so on. A great deal of managerial attention to cost control is necessary to

achieve these aims. Low cost relative to competitors becomes the theme running through the entire strategy, though

quality, service and other areas cannot be ignored” (italics added).

Thus, the strategy involves making a “fairly standardized product and underpricing everybody else” (Kiechel,

1981b, p.181).

2.1 Major reliance on modern capital equipment

The cost leadership strategy requires “heavy up-front capital investment in state-of-the-art equipment”

(Porter, 1980, p.36). So, Kiechel (1981a, p.140) says that in order to maintain cost leadership, a firm should

therefore “buy the largest, most modern plant in the industry”. In basic industrial commodities—such as pulp,

paper, and steel—“knocking a couple of percentage points off production costs has far more strategic impact than

all the weapons the marketer could employ in these industries” (Bennett & Cooper, 1979, p.82). Porter (1980,

p.43), also, points out that in many bulk commodities “it’s solely a cost game”. So, cost leadership strategy makes

a lot of sense in such industries (Mintzberg, 1988, p.15). However, we shouldn’t forget Levitt’s (1980) dictum,

discussed later, that even a so-called commodity can be differentiated.

In most other markets, differentiation is much more critical. So, investing a big fortune in state-of-the-art

equipment in the absence of some advantage in the market means putting too many eggs in the low-cost basket.

2.2 Relying on experience curve to underprice competition risky

According to this theory, the market-share leader can underprice competition because of its lower costs due

to its cumulative experience, “thereby further hastening its drive down the curve” (Kiechel, 1981a, p.140).

A frequent result of such an aggressive strategy can be a “kick-’em, punch-’em, wrestle-’em-to-the-ground

price war” (Kiechel, 1981a, p.140). Wars like these are quite bloody and often end without winners. Because price

cuts are easy to imitate, they may not result in a long-term advantage (Wensley, 1981). Since price is the primary

competitive weapon of such a strategy, this approach implicitly assumes that most products are commodities

(Giddens-Emig, 1983). Texas Instruments’ sad experience in the consumer watch market is a good case in point

(Peters & Waterman, 1982; Porter, 1985, p.13). Dupont’s adventure in the nylon market may be one more example

of a similar failure (Kiechel).

Another disadvantage of competing on price is that it can lead to a “cut rate” or “discount” image that may be

hard to overcome. One example is Sharp which tried to compete on the basis of price even though it was offering

quality products that were favorably rated (Rachman & Mescon, 1979, p.218; Porter, 1980, pp.45-46). Also it is

far easier to cut prices in order to gain market share, but it is much more difficult to try to do the opposite, i.e., to

2

Except their two focus strategies.A critique of Porter’s cost leadership and differentiation strategies

39

raise prices in order to make some money, as Du Pont found out in its nylon business (Kiechel, 1981a).

2.3 No such thing as a “commodity”: Everything can be differentiated

Levitt (1980) points out that everything can be differentiated—even a commodity. Peters and Austin (1985,

p.61) declare that they just despise this word. They argue that if we put the label of commodity on a product it

becomes a self-fulfilling prophecy. Buzzell and Gale (1987, p.113), too, warn that “if you think of your

product/service offering as a commodity, that’s what it will be—a commodity”.

In consumer markets, even simple products, such as chicken, bananas, potatoes, oranges, etc. are now

differentiated through branding (Levitt, 1980). This trend toward branding also includes ingredients. For example:

DuPont’s Lycra, Teflon and Stainmaster; G. D. Searle’s Nutrasweet and 3M’s Scotchgard (Norris, 1992).

Caves (1987, p.22) argues that with the exception of industrial markets, most manufacturing industries that sell

to other manufacturers are “nearly free of differentiation”. He adds that these so-called undifferentiated commodities

are sensitive to price. However, Levitt (1980, p.84) says that this belief in high sensitivity of undifferentiated

commodities to price is “seldom true except in the imagined world of economics textbooks”. For example, he states

that when Detroit (the auto-industry) buys sheet metal it stipulates exceedingly tight technical specifications, various

delivery schedules, responsiveness in reordering, and the like. In addition, Detroit has an elaborate rating system for

evaluating supplier performance. Thus, Detroit does not regard sheet metal as just a “commodity”.

Interestingly, Porter (1985, p.121), too, agrees with Levitt’s position.

In price-sensitive markets where prices tend to be uniform a business can gain competitive advantage by

achieving differentiation based on service (D’Aveni, 1994, p.48; Friedman, 1983, p.54; Gale & Buzzell, 1989;

Hambrick, 1983). Even Caves (1987, p.22) admits that undifferentiated commodities may achieve some

differentiation due to a seller’s reputation for reliable delivery, or the supporting services provided. Lawless (1991)

suggests that sellers often use commodity bundling—combining the physical product with service—to

differentiate themselves in the market.

2.4 Porter identifies high market share with cost leadership strategy

Porter (1980, p.36) maintains that achieving “a low overall cost position often requires a high relative market

share or other advantages, such as favorable access to raw materials” (italics added). But, how does one acquire

high market share in the first place? The answer is that market share leaders accomplish this distinction via a

strategy of differentiation—higher quality—rather than through cost leadership (Hambrick, 1983; Gale, 1992).

2.4.1 Porter—GM successful follower of cost leadership strategy

Porter (1980, p.43) cites General Motors (GM) as a successful practitioner of cost leadership strategy. But,

GM’s past success raises an important question. How did GM become a low-cost leader? Was it because of a

pursuit of cost leadership strategy, or was low cost mainly the result of the high market share GM was able to

achieve due to differentiation?

2.5 Differentiation the genesis of GM’s past success

It was GM’s CEO Sloan who pioneered the strategy of “a car for every purse and purpose” (Cray, 1980,

p.243). In 1921 he rationalized GM’s cars into five3

price-quality segments––from a Chevrolet, to a Pontiac, to an

Oldsmobile, to a Buick, to a Cadillac. In order to differentiate GM brands from their competition, he positioned

each car line at the top of the price scale within its price-quality segment (Sloan, 1972, pp. 73-74; Datta, 1996).

GM’s broad scope in serving multiple segments in the auto industry provided it an advantage that such a

3

Originally, Sloan offered GM’s cars in six price-quality segments.A critique of Porter’s cost leadership and differentiation strategies

40

strategy can bring about in gaining a low cost position, as Porter (1985, p.12) has indicated earlier.

The most revolutionary development in the American automobile market then was the popularity of the

closed-body cars (Sloan, 1972, pp.183-184). At that time Ford was following a classic cost leadership strategy

with the low-price model T (Porter, 1980, p.45). With a single-minded focus on improving manufacturing

efficiency, he strongly believed in producing a standard product at the lowest price. He said the customer can have

a car in any color so long as it is black (Datta, 1997).

The sharp rise in demand for the closed-body cars made it impossible for Ford to sustain his market share

leadership. This is because Ford had “frozen his policy in model T” which was essentially an open-car design;

with its light chassis, it was ill-equipped for the heavier closed-body car (Sloan, 1972, p.186).

In 1921, Ford had 60% of the car and truck market in units, while Chevrolet had only 4% (Sloan, 1972, p.76). So,

in 1925, GM came out with a plan of attacking Ford with a closed-body Chevrolet (with a self-starter) that offered more

value at a somewhat higher price—a move that was a “resounding success” (Cray, 1980, pp.230-231; Datta, 1997).

Following the success of Chevrolet, Sloan (1972, p.186) made the comment that the “old master had failed to

master change” (also Porter, 1980, p.45).

The 1920’s decade was an era of increasing affluence (Cray, 1980, p.218). Then customers demanded cars

that provided “comfort, convenience, power and style” (Sloan, 1972, pp.187-188). Yet, Ford stubbornly clung to

his belief that a new car was supposed to meet the need for basic transportation. However, after 1923, this demand

was being met primarily by the used car market (ibid). As customers bought more new cars, they traded-in their

old ones, and so the used car became the chief rival of Ford’s model T (Cray, 1980, p.220).

Following the above developments the sales of model T declined precipitously. In response, Henry Ford

closed his River Rouge plant for nearly a whole year to retool. However, he could not recover from this calamity,

and finally lost the market share lead to Chevrolet for good (Sloan, 1972, p.187).

Although, the closed-body design with which GM attacked Ford was ground-breaking, Sloan adopted a

rather cautious approach to differentiation. According to this policy, GM cars were to be “at-least equal in design

to the best of our competitors in a grade, so that it was not necessary to lead in design or run the risk of untried

experiments” (Sloan, 1972, p.72). This reference by Sloan to “untried experiments” was a fearful reaction to GM’s

failure to develop an innovative air-cooled engine for Chevrolet. So this mind-set became ingrained into general

policy that would later dominate corporate thinking: “don’t innovate” (Cray, 1980, p.198).

Another innovation that can be attributed to Sloan is incorporating the economies of scope in GM’s strategy. Sloan

decided to use Chevrolet parts for “Pontiac which was essentially a lengthened Chevrolet” (Cray, 1980, p.248). This

was in contradiction to the conventional wisdom at that time that mass production required a uniform product. However,

Sloan showed that mass production and product variety could both be pursued together (Sloan, 1972, p.181).

The Japanese conquered the U. S. small car segment during the seventies, as reported later. So, how did GM

non-luxury mid-size and large cars compare in quality with Ford and Chrysler before the Japanese entered these

segments? Based on Consumer Reports data from 1976-1982, GM clearly outperformed both companies in these

two segments.4

4

The data in this analysis was taken from the annual guides. From the model years 1976 through 1982, GM full-sized non-luxury

cars scored first and second in every year except Ford’s second place for 1981 (no data reported for second place for 1982). Similarly,

GM also made a clean sweep of the domestic midsize/compact category for the same period except for Dodge’s first and second

showing for 1982 and 1977 respectively. These two categories of cars probably represented the biggest and most profitable segments

of cars in the U.S. for that period.A critique of Porter’s cost leadership and differentiation strategies

41

GM dominated the U.S. auto industry like a colossus for half a century with a market share as high as 54% in

1954 (retrieved from http://seekingalpha.com/article/122761-as-gm-goes-so-goes-the-nation-part-1) which made

it the low-cost leader in the industry. However, as pointed out above, this cost leadership was primarily the result

of two strategies: differentiation and broad scope.

2.5.1 The decline of General Motors

During the earliest years in the U.S. automobile industry, most improvements were mechanical in character.

But, by the end of 1920 the industry saw fewer and fewer mechanical improvements. The “new and improved”

models the American public expected from Detroit were “new and improved” only by the “addition of

convenience and the dint of advertising” (Cray, 1980, p.246).

So, Sloan (1972, p.188) instituted a policy of annual model change that became standard industry practice.

This policy—that later came to be known as “planned obsolescence”—was instituted to increase demand by

inducing customers to buy new cars frequently, because the new models made the older ones look unfashionable

and therefore undesirable (Cray, 1980, p.235).

Sloan also masterminded another strategy with far-reaching implications. He became convinced that future

sale of GM cars “rested not on technology, but on their “looks”: “body design, the paint schemes, the richness of

the interiors… to differentiate them from their mechanically identical competitors” (Cray, 1980, p.245).

Thus, the policy of “planned obsolescence”, a focus on cosmetics rather than technology, and the attitude of

“don’t innovate” had sown the seeds of GM’s decline. For too long GM had pursued a notion of quality that was

literally skin deep. GM’s dominance of the auto industry allowed it to set the rules of the game that were anchored

in style—an area GM had made a part of its core competence. GM was clearly the king when the competition

consisted solely of the much weaker rivals Ford and Chrysler. However, GM found it was in a different league

when the Japanese and the Germans joined the competitive arena. Also, while multiple brands might have been a

good strategy for GM in the past, it is not so in today’s global competition in which successful firms like Toyota

concentrate on a limited number of car lines (Womack, 2006).

So, it is sad to see that GM, an American icon, had to file for Chapter 11 bankruptcy. Now that it has emerged

out of bankruptcy, we hope the new GM will have a bright future.

2.6 Mintzberg: Cost leadership is “price differentiation” strategy

Porter (1985, p.13) says that “a cost leader cannot ignore the bases of differentiation,” and “if its product is

not perceived as comparable or acceptable by buyers, a cost leader will be forced to discount prices well below

competitors’ to gain sales,” and this “may nullify the benefits of its favorable cost position”. Mintzberg (1988,

p.15) argues that the implication of the above statement by Porter is that “price differentiation may have to follow

cost leadership, implied almost as a necessary evil” (italics in the original).

Porter (1985, p.13) suggests that a cost leader “must achieve parity or proximity in the bases of

differentiation relative to its competitors” (italics in the original). A cost leader cannot be an “above-average

performer” unless it can “command prices at or near the industry average”. But, asks Mintzberg (ibid): “What

would enable it to command such prices?”

As already stated, the essence of cost leadership strategy (Porter,1980, p.35; 1985, p.13), includes producing

a “standard, or no-frills” product, “tight cost and overhead control, avoidance of marginal customer accounts, and

cost minimization in areas like R&D, service, sales force, advertising”, etc. Mintzberg (1988, p.15) says that is

“all good for the cost side of the ledger”, but “hardly the basis for attracting customers”. 6. Conclusion

An extensive review of Porter’s cost leadership and differentiation strategies has revealed four major themes.

First, he identifies high market share with cost leadership, citing GM as a successful practitioner of this strategy.

But GM became a market share leader in the U.S. auto industry mainly because of a strategy of market

segmentation, differentiation and a broad scope devised during the 1920s.

Second, he suggests that cost leadership and differentiation strategies are an equally viable path to

outperform the competition. However, a differentiation strategy based on superior quality relative to competition

is more profitable than cost leadership strategy. It can lead a business to become a market share leader and

therefore even a low-cost leader.

Third, Porter’s generic strategies are overly broad and present a narrow view of differentiation with a unique

product—sold at a premium price—on the one hand, and a “standard, or no-frills” product on the other.

Fourth, Porter affirms that cost leadership and differentiation strategies—as he has defined them—are not

just dimensions that could be mixed or matched to formulate a strategy. Rather, each strategy requires a different

culture and a different philosophy. Nonetheless, research indicates that differentiation and cost leadership can

actually go together.

Mintzburg (1988) suggests that Porter’s cost leadership should be called “price differentiation” strategy

because it relies on a price that is lower than that of the competition. He also says that business strategy has two

dimensions: differentiation and scope. So, setting scope aside competitive strategy has only one component:

differentiation. The important question is not whether to differentiate, but how?

First, customer-perceived quality should be the cornerstone of competition, because it is far more critical to

long-term success than any other factor. Second, in consumer markets the best road to market share leadership is

serving the middle class by competing in the mid-price segment, and offering superior quality compared to the

competition, at a somewhat higher price. This is essential for two reasons: (1) to maintain an image of quality; and

(2) to ensure the strategy is both profitable and sustainable.

Finally, cost leadership strategy is internally rather than customer oriented. However, this deficiency

represents a more general problem. The “word customer rarely appears in management journal article titles,

management textbook indexes, or session titles at the Academy of Management meetings” (Dean & Bowen, 1994,

p.408; italics added). No wonder “customer” represents a big gap in management theory (Datta, 1997).

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