How Do Cost Advantage and Differentiation Lead to Competitive Advantage?

How do cost advantage and differentiation lead to competitive advantage?

By Alaa Ahmed

Introduction

Today as we live in the 21st century, business has not only become an art, but also a science. What makes business a science are the concepts and theories that are being developed by scholars, which help people to build their business with a scientific method. For instance, one of the most important concepts in business nowadays is competition, which has become widely spread in today's world. The reason behind that is the increase in the number of firms that produce the same products or services while striving to be the best-selling. If you want to start a business or stay in business, you have to have some advantages over your competitors, since you need to answer the question "How I will attract customers to buy my products not my rivals' products?" The answer will be based on the advantages you have over other competitors. However, these advantages have to be competitive in order to beat your rivals since you deal with competition. Gaining a competitive advantage has become the most important subject of research in strategic management.

Many firms strive for a competitive advantage, but few truly understand what it is and how to achieve it and maintain it. What results from competition is the success or failure of a firm. Thus, staying in business is based on how strong the firm is and this strength is measured by the advantages that the firm has. Whether these advantages are competitive or not is considered the criteria of strength. So, what is a competitive advantage? "It's what keeps your business alive and growing" (Smith & Flanagan, 2006, p. 1). To put it differently, it means the advantage you have which differentiate you from others. Michael Porter, a professor at Harvard Business School says "competitive advantage is at the heart of a firm's performance in competitive markets" (Porter, 1985, p. xv). It can be also viewed as any activity that creates superior value above its rivals. Competitive advantage is essentially a position of superiority on the part of the firm in relation to its competition in any of the multitude of functions/activities performed by the firm. Scholars in business field have been studying and researching for how a firm could create a competitive advantage. They have identified strategies that can lead to gaining a competitive advantage of which the most important are the cost leadership and differentiation strategies. It can be gained by offering the consumer a greater value than the competitors, such as by offering lower prices or providing quality services or other benefits that justify a higher price. The strongest competitive advantage is a strategy that cannot be imitated by other companies. Hence, if a firm is to gain competitive advantage, it has to apply either the cost leadership strategy or differentiation strategy. A firm that utilizes a cost leadership strategy seeks to be the low-cost producer, relative to its competitors. Whereas utilizing a differentiation strategy, a firm will be unique in a specific part such as quality, branding, or service. In this paper we will find how these two strategies lead to gaining a competitive advantage and the drawbacks if implemented.

I. Cost leadership strategy

Often, cost has direct impact on firm's sales since price and margin are based on the amount of cost and whenever the price is lower than other competitors' price, selling increase. Michael Porter identified cost leadership strategy as one of these strategies that lead to gaining a competitive advantage (1985). A cost leadership strategy related to a marketing strategy that price is considered the tool for that strategy and the objective is market share leadership. A cost leadership strategy is based on a marketing strategy in which price is the main strategic tool and where the business objective is market share leadership. In order to achieve the goal that you aim by applying this strategy, you need to be the leader in lower-cost. Now the question is" what are the costs of production you may able to reduce them?". Companies could think about the main costs of production as tools to implement cost leadership strategy.

There are two types of costs, fixed cost and variable cost. For instance, the cost of machine extinction, rent of warehouse, cost incurred by utilities, and workers' salaries are considered fixed cost. Raw material that used to produce something and any other materials that have positive correlation are considered a variable cost.

Implementing cost leadership strategy

- Fixed cost

Usually, production process undertakes by company resulting costs. Part of these costs is fixed and the other is variable. For example, Warehousing activity results costs weather before production by stocking raw materials needed for producing or after production by stocking the final product. This cost is considered fixed cost since this cost does not change while the production increase and vise versa. Another example of fixed cost is the cost of assets extinction. Company is able to reduce this fixed cost of warehousing by using many methods. Just-in time is one of these methods. The idea of (Just-in time) is to produce by order. When a company receives an order; instantly, will buy the required raw materials to produce and delivers the final product to the customer. According to American Business organization "Just-in-time (JIT) reduces the cost of having expensive materials sitting idle while waiting for production and eliminates the cost of having expensive equipment sitting idle while waiting for materials" (Just-in-time production (JIT), 2010). In other words, by using JIT method, the need for stocking raw material or final products will be denied. Regarding assets extinction cost, the company could reduce it by using Mass-production method. The amount of products workers could produce is limited by working hours. However, the company could produce more than the limit number at the same working hours by using new technology or replace exciting machines by modern one. Consequently, the cost of extinction will be reduced because this cost associated with operation hours not by the number of product. However, reducing fixed cost is not enough for a firm to be a cost leader; it needs to work on reducing variable costs, too.

- Variable Cost

Variable cost is expenses that vary in direct proportion to the quantity of output. In other