In thinking about strategies that can help companies achieve a strategic fit, the field of strategic management has developed a set of so-called generic business strategies. These strategies are generic in the sense that they can apply to many different firms and in many different contexts. The two main generic business strategies are cost leadership and differentiation advantage. Each of these two strategies refers to a distinct way in which companies can create competitive advantage. In cost leadership, the company produces products or services that are similar to it's competitors, but at a lower cost. In differentiation advantage on the other hand, the company produces products or services that are unique and different from competitors and can therefore command a price premium. While there are many examples, the contrast between these two strategies can readily be seen in the department store industry. The giant US retailer Walmart is a typical example of a cost leader. There are similar low-cost retailers like Carrefour and Metro in other countries as well. At the other end of the spectrum are the more high-end differentiated department stores like Nordstrom and Bloomingdale's in the United States and Harrods or [inaudible] in Europe. Let us now try to understand cost leadership and differentiation strategies at a more fundamental level. What do they mean for the value that a business delivers to its customers or the costs that are incurred in delivering that value? What do they mean for economic value added, EVA? How does a business generate a profit when either of these two strategies are used? The key insight is that cost leadership strategy places most of it's emphasis on controlling costs in order to generate economic value added and profits. A differentiated strategy does the opposite. It emphasizes value creation for customers rather than cost-control and produces higher EVA and profits in that way. Let me show this to you graphically. In this first graph is a typical or average industry competitor. This representative competitor incurs a certain cost but produces more value for customers and thus creates some economic value added as shown here. Now see what happens with a cost leadership strategy in the second graph. The cost leader focuses on trying to bring costs down while trying to maintain comparable value creation to the average industry competitor. Now because it's able to bring costs down more substantially than the corresponding reduction in customer value, a cost leader can price in such a way as to undercut it's typical competitors and still make a good profit. Does low-cost competitors often employ Sam Walton supposed formula when he started Walmart? Buy cheap, sell for less than the other guy and make your profit on high volume and fast turnover. But please note that this is a low cost strategy, not a low price strategy, which is in fact not a strategy at all unless it's backed by the ability to keep costs low. Differentiation employs a somewhat different approach, often in key branded consumer product categories. Robert Goizueta, former CEO of the Coca-Cola Company, is quoted as having said, "If the three keys to selling real estate are location, then the three keys to selling consumer products are differentiation." With the strategy of differentiation advantage, companies focus on increasing the value created for customers, often a subset of customers. Cost containment is not a major preoccupation, but it is nonetheless important that costs don't rise too much. Then a successful differentiator can charge a price premium above what it's typical competitors may charge and may still be able to attract customers because of the value being provided to them. If costs are in check, the price charge should be adequate to generate a nice profit. In both strategies, the profits that we have mentioned are economic profits, which means that they are profits earned after paying the full cost of capital, which are included in the cost. Thus the firm's profit performance would actually be quite attractive indeed. You might be wondering how exactly a company can produce a cost or differentiation advantage over its competitors. The key here is to understand what drives cost or customer value in a particular business, and then figure out how the firm's internal capabilities, resources, or activity systems, that is it's value chain or value network can be modified, enhanced, and applied to these cost or value drivers. Let us take costs first. In some ways, cost leadership is simple to understand because the ultimate goal is very clear. Reduce the expense of producing the company's product or service. However, there are many things that can affect cost in a business. Here you can see a list of some of the more important ones. For example, scale and learning economies can be important in some processing or manufacturing related industries. Also input costs and specific costs reducing production techniques. I want to especially highlight managerial inefficiency or bureaucracy because that can be a big source of hidden costs in many businesses today and provide a very significant opportunity for a low-cost strategy. A key idea behind this cost drivers exercise is to study the business and prioritize where are most of the costs being incurred? Once the main drivers of costs have been identified, we can turn to how these costs can be reduced. Now let's say you're trying to reduce input costs for Walmart. The costs of the products, it stocks in it stores. Can you think of some ways in which you can use the leavers of resources, capabilities, or activities to reduce Walmart's input costs? Here's some things that Walmart already does to control input costs. Some input costs are reduced by building or acquiring key resources. A network of warehouses, say, a fleet of trucks, a good IT system for managing the logistics, etc. Walmart has also done especially well at developing strong supplier relationships. Another resource, and building a great procurement capability. Walmart's procurement capability includes a number of key activities like gathering detailed supplier cost data, analyzing consumer buying behavior, collecting price sensitivity data, and hardball negotiation tactics with suppliers. Using this approach, you could look at any of the cost drivers of a business and then ask yourself how the firm's resources, capabilities, or activities systems can be augmented and used to reduce these costs. Of course, the goal here is to reduce or eliminated unwanted costs that add very little or no value. To pursue a differentiation advantage, a firm needs to identify leavers that can help it increase value for customers. Now, the interesting thing about value is that unlike cost, it does not come in one currency. To figure out what kinds of things might drive customer value, companies need to rely on market research and combine that with their own insights about customers. Some common factors that can affect customer perceptions about value include product features. Think about smartphones, for example, every month there's some new phone in the market with some new must-have feature that they're trying to entice customers with. This one has so many megapixel camera, it has some new security device, a better Cloud backup service, a better way to retrieve your phone if you misplaced it, it doesn't break or damage in water, the list goes on and on. Then there's Customer Service, which in some industries like hotels, can be very important for customers indeed. Customer value can also be based on customization. A nice example is Starbucks Coffee. I'm always amazed at the number of different combinations that I can possibly buy at Starbucks. In coffee's alone, there are four basic types, espresso, latte, cappuccino, and Americano, and four possible cup sizes and then there are all the variations just within the latte; vanilla latte, mocha, white chocolate mocha, pumpkin spice latte, etc. Then I can choose how much coffee; decaf, half-caf, single shot, double shot, and all the types of milk; nonfat, two percent, whole milk, half-and-half, soy, whip cream or no whip cream, how hot you want it. The list goes on and on. Someone has calculated that there are over 200 million combinations of coffee drinks possible at Starbucks even before you begin to use the full range of syrups that they have. The important thing here is that a lot of people go to stores like Starbucks because they want their product or service to be customized, it's a source of value to them. Customers can also gain value from compliments. A lot of the value that customers saw in the Apple iPod was the ability to buy legal music, the complement from the iTunes Store. Once we know what kinds of things customers value, then it is back to figuring out how to use resources capabilities of the firm's system of activities to create that value. Starbucks creates the customization around its coffee through its investment in some good equipment, recruitment and training of its staff, as well as a set of activities surrounding order placement and delivery. For example, some of these activities include the fact that every order gets repeated multiple times from cashier to barista and back again, which all customers hear, and thus begins to educate customers about how to customize their coffee orders. It begins to reinforce the value creation in Starbucks through customization. Now in addition to the cost differentiation distinction, each generic strategy can also be applied with broad scope, for example, the most customer segments in sales channels, or with narrow scope, only to specific segments and or channels. The resulting combinations create four possible generic strategies: broad cost leadership and broad differentiation and narrow or focused low cost, and focused differentiation. What purpose is served by limiting scope when pursuing a cost or differentiation-based strategic positioning? This is a little bit easier to see when considering differentiation, so let's start there. When you think about differentiated luxury products like Prado or Ralph Lauren, Lamborghini cars or Rolex watches or Louboutin shoes, you might instinctively sense that they are targeted at a narrower market segment and limited distribution channels. Here, narrow scope and differentiation seem to be a natural fit, partly because being more focused helps promote the aura of exclusivity around the product, making them more valuable to customers. If Prado was sold in every little departmental store, it might lose some of its cache value as a high-end product. Additionally, being narrow in channeled scope might also help to contain some costs because the volumes in which these products will be sold at non luxury retailers may be too small to justify the logistics, inventory, and potential unsold stock. Using a narrow scope strategy can also help firms with cost leadership. Now, this might seem a bit counter-intuitive because we often think of scale as being useful to reduce cost. But some businesses may not have significant scale economies to begin with. Moreover, it may actually be possible to reduce costs by avoiding some customer segments that are too costly to serve. For example, the hamburger chain checkers or rallies, they're one company, cater predominantly to drive-through sales and have drive-through lanes on both sides of the restaurant. Clearly, they're losing some eat-in customers, but they avoid the real estate and operational cost of catering to these customers and have lower costs overall by focusing on the drive-through business. The Swedish so-it-yourself furniture chain, IKEA, is another example of a business that's low cost and narrow scope. IKEA does not want to sell to customers who want their furniture pre-assembled as they are too costly to serve. Similarly, the insurance company, GEICO, only sells to customers through the phone and Internet, not through insurance agents, so they are focused by channel. This helps them avoid many of the costs of managing insurance agents, even though they undoubtedly lose some business as a result. Moreover, GEICO provides a nice example of how having broad scope can sometimes undermine the low cost model entirely. If GEICO used agents to sell its insurance, these agents would likely want GEICO to guarantee parody and rates with what GEICO charges in its direct channels. Now, this type of coordination can begin to undo GEICO's competitive advantage entirely as the agent-based channel is unlikely to be cost-competitive with the direct-to-customer channel. GEICO's entire strategy is to lower costs in various ways, including the direct-to-customer channel and under price other insurance. Quite simply, coordinating the direct channel with an insurance agent space channel would be a hassle that GEICO would rather avoid. What did we learn in this lesson? Well firstly, we learned about four possible generic strategies with which a company can strategically position itself: broad cost leadership, broad differentiation, focused low cost, and focused differentiation. Secondly, we learned that to achieve cost leadership or differentiation advantage, a firm needs to identify drivers of cost in the business or drivers of customer value, and then apply its resources, capabilities, or activities to these cost or value drivers in order to create a competitive advantage.