Cost Leadership vs Differentiation: Where the Advantage Lives
Where does this pair come from, and whose is it?
Michael Porter set out the generic competitive strategies in Competitive Strategy: Techniques for Analyzing Industries and Competitors, published in 1980, and cost leadership and differentiation are two of them. Porter's naming matters more than it looks. A reader who meets the pair as neutral technical vocabulary will treat it as a menu, and treating it as a menu is the one reading the original account never permitted. Porter also gave a name to a business that has committed to neither, and the phrase is his: being stuck in the middle.
So take the pair back to what it was. Not two boxes to tick. Not a dial that runs from cheap at one end to fancy at the other. Two separate questions, put to one business, about two different places an advantage could be sitting. One of those places is inside the cost structure, in what the business pays out and what its works turns that into. The other is inside a decision somebody else made, in what a buyer will hand over and why.
The whole account of what each strategy is, run at length with the three of them counted out, is set out under The Sources of Competitive Advantage. The narrower job is to take the two as questions, show where the evidence for each would have to sit, and then put both of them to one set of accounts to see what comes back.
Michael Porter set out cost leadership and differentiation together in 1980. What did that account treat the pair as?
What does the cost question actually ask?
In one line: it asks whether the business can make and deliver the same thing for less than a rival can, and whether that comes from how the business is built rather than from how last quarter happened to go. A rate that was low in March and normal in April is not the cost question answering itself. A rate like that is weather. The full account of the strategy, and of what makes a cost position structural rather than lucky, is set out under The Sources of Competitive Advantage.
Where the evidence would have to come from is the narrower question, and the answer is pleasingly narrow. Cost evidence is a rate the business paid or a quantity its works converted, and both of those already sit inside the accounts. A rate on an input. A count of what went in against a count of what came out. A unit costwhat one finished item carries of everything the business spent, worked out by spreading the spending across the number of items made. that somebody can rebuild from the two figures underneath it. None of that has to be gone and found. The accounts already hold it, and holding it is what a set of accounts is for.
Two chai stalls stand outside one office gate. One of them takes a whole crate of milk every morning, and because it does, the dairy quotes it a rate the second stall has never been offered. Nothing about that is mysterious and nothing about it is hidden. Either stall, asked what it paid, could say, and the difference between the two answers is exactly the shape a cost advantage takes. A cost advantage is a rate, on a thing, against somebody.
What does the differentiation question actually ask?
In one line: it asks whether the buyer will pay more, or simply keep buying, for a reason that has nothing to do with price. The strategy itself, with its three siblings counted out and named, is set out under The Sources of Competitive Advantage. The comparison needs the same narrow thing from it as before. Where would the evidence sit?
Somewhere much less convenient. Buyer evidence is something a buyer did, and there is usually no line anywhere in the statements that records it. A customer who renewed without asking for a quote does not generate an entry. Neither does a purchase manager who stopped putting the job out to three suppliers four years ago. Neither does an order bookthe list of orders a business has already received and has not yet delivered against, kept as a working record rather than as part of the published accounts. that fills up at the same time every year without anybody making a call. All of that is real, all of it is doing work, and none of it arrives as a figure.
Back to the two chai stalls. The second one has the same faces every morning, and the reason is that the owner remembers how each person takes it, no sugar for one and extra ginger for another. The remembering is worth something, and it is why the stall is still there. And there is no book anywhere in which it is written down, so an audit of both stalls on paper would show one of them looking like it had an advantage and the other looking like it had nothing, when what is actually true is that one advantage happened to be countable and the other did not.
The absence of a line in the accounts is not the absence of the thing. Somebody who quietly assumes the opposite builds the scoring sheet failure, and that one sentence carries more weight than any figure in the accounts.
A business can buy its main input at a rate no rival has been quoted. Which of the two questions does that evidence answer?
Which question does a given item of evidence answer?
The whole test takes one question rather than a framework. Somebody offers a fact about a business and calls it an advantage. The question is which side of the transaction the fact came from. If it is a rate the business paid, or a quantity its works converted, it belongs to the cost question. If it is something a buyer did, it belongs to the other one. That is it. The trade, the size and the year are all unnecessary to running it.
The test buys order. Two people are answering two different questions and neither has said which, so most arguments about competitive advantage go wrong before any evidence is weighed. Ask which question the evidence answers before asking which strategy the business has. Until the first question is settled, the second has no answer.
And then the part that people find uncomfortable. The two branches do not rejoin. The two answers are not measured in the same thing, so they do not add up, and a comparison that adds them has made up a unit of its own. Both answers can be held at once. The two answers cannot be averaged, weighted, or reduced to a single reading, any more than a temperature can be averaged with a distance and the result reported in degrees.
The Sunrise Public School group has bought from Anjani Stationers for eleven years and the order book refills each spring without anybody persuading the schools again. Which side of the transaction is that evidence on?
What does the cost side of one real set of accounts hold?
Anjani Stationers Private Limited, an invented stationer, has a year two set of accounts, and two figures in it belong to the cost question. Both are taken as inputs rather than built. The construction of the first, and what its shortfall costs in paper, is set out under Throughput. The construction of the second, and the reason its gap must be reported the way it is, is set out under Procurement.
The first is the conversion yieldthe share of what a process could have produced from the material it consumed that it actually produced, worked out as output achieved against output possible.. The works consumed 71,000 reamsa counting unit for paper. One ream is a fixed bundle of sheets, so paper is bought, stored and charged by the ream rather than by the sheet. and finished 2,50,000 registers, against the 3,55,000 that a perfect conversion of five registers from every ream would have given. The yield is 70.42 per cent. The comparator belongs with the figure every single time it is written down: Anjani Stationers against its own perfect conversion, and against no competitor at all. Nobody else's yield is on record, so no rival enters the comparison.
The second is what the business paid for paper. Anjani Stationers bought 75,000 reams for Rs 1,57,50,000/-, a weighted averagean average that lets each figure count in proportion to its size, so a rate struck on a large quantity pulls the result further than the same rate struck on a small one. of Rs 210.00/- a ream. The business did strike Rs 200/- once during the year, on 15,000 reams, and those reams are 20.00 per cent of the volume. Pricing the whole 75,000 at Rs 200/- gives Rs 1,50,00,000/-. The difference against what was actually spent is Rs 7,50,000/-, and that gap is 18.07 per cent of the year's operating profitwhat the trading of a business earned in the year before interest and tax are taken off, so it reflects the running of the business rather than how it is financed. of Rs 41,50,000/-.
The gap of Rs 7,50,000/- is a ceiling rather than a saving, and it has to be labelled that way on every occasion it is written. Nobody has quoted Rs 200/- on the other 60,000 reams, four fifths of the year, so no such money was ever on offer and none of it was passed up. The ceiling marks the outer edge of what better buying could have been worth across those twelve months, computed from a rate that was genuinely achieved once. The figure the year actually settled at is Rs 210.00/- a ream, so the reading that follows is uncomfortable rather than flattering. Anjani Stationers shows no evidence of a purchasing advantage.
| What was counted | Figure | What it is set against |
|---|---|---|
| Reams consumed in the works | 71,000 | the registers those reams became |
| Registers finished | 2,50,000 | 3,55,000 at five registers a ream |
| Conversion yield | 70.42 per cent | its own perfect conversion, and no rival |
| Reams bought in the year | 75,000 | Rs 1,57,50,000/- of spending |
| Weighted average rate paid | Rs 210.00/- | the Rs 200/- struck on part of the volume |
| Reams bought at Rs 200/- | 15,000 | 20.00 per cent of the 75,000 |
| Reams never quoted at Rs 200/- | 60,000 | the reason the gap is a ceiling |
| Whole year priced at Rs 200/-, against what was spent | Rs 7,50,000/- | 18.07 per cent of Rs 41,50,000/- |
Both counts underneath each ratio in the table sit beside it. A ratio that can be rebuilt need not be trusted.
One sentence remains to be said about both findings. Each is either a rate the business paid or a quantity its works converted, and neither is something a buyer did, so both are cost evidence. Two findings, one column, and the other column of the comparison still completely empty.
Anjani Stationers paid a weighted average of Rs 210.00/- a ream across the year and struck Rs 200/- on 15,000 of its 75,000 reams. Before reading on, what does the Rs 7,50,000/- gap between the two represent?
What does the buyer side of the same accounts hold?
One thing, and it is not a number. The Sunrise Public School group has been buying from Anjani Stationers for eleven years. Every spring the order book fills again for the new school session, and nobody at Anjani Stationers has to go back and win the schools over as though for the first time. The renewal has stopped being a decision that anybody at the schools consciously takes.
There is no cost side reading of that fact available at all. It is not a rate, it is not a quantity converted, and it appears on no line of any statement. The cost column takes rates and counts, and eleven years of somebody not switching is neither, so there is nothing to file in it. The duration is still evidence, and evidence of exactly one thing. The schools are not treating the purchase as an open question.
Now the limit. A duration is evidence that a switching cost exists and it is not a measure of one. Eleven years does not say how much friction there is. The duration does not say what the schools would tolerate before moving, or what it would cost them to move, or how much of the relationship is habit and how much is genuine difficulty. Turning the eleven into a quantity would be making up a figure and dressing it as a finding. Whether the Anjani Stationers name is worth anything on its own is a separate matter and is set out under Brand Equity, and how to read a customer list for dependence is set out under How to Analyse Customer Concentration and Dependence.
Eleven years of continuous buying is published for Anjani Stationers. What can that duration be used as?
What happens when a business can answer neither question?
Put both questions to Anjani Stationers now, with everything the year published sitting on the table, and watch what comes back. On the cost question there is a real operating gap and there is a real rate. The yield is set against the works itself and the rate is the one the year actually settled at, so neither establishes anything against a competitor. On the buyer question there is a relationship eleven years old. The relationship says the schools have stopped deciding and says nothing about how much friction is holding them.
The honest reading is competitive paritythe ordinary state in which a business is neither better nor worse placed than the people it competes with on the thing being examined, so no gap exists in either direction. on both questions, and parity is the ordinary case rather than a diagnosis. Parity is not a verdict on the business and not a finding that something has gone wrong. An advantage is a gap against somebody, so a figure with no comparator beside it cannot be one, however solid the figure is. And most of any business, including the ones that do carry an advantage somewhere, is parity almost everywhere else.
Michael Porter's name for a business that has committed to neither strategy is being stuck in the middle, and the phrase has a sting in it that the ordinary case does not deserve. So say the plainer thing instead. Most businesses are at parity on both questions. Most of any single business is at parity on both questions. A reader who goes looking for an advantage will find one whether or not it was there, so writing down parity is more useful than producing an advantage.
Anjani Stationers' conversion yield of 70.42 per cent is measured against its own perfect conversion of five registers a ream. What follows?
How many answers do two questions actually produce?
One reading of the pair has to be defeated before anything else, and it is very common because it feels tidy. The pair gets drawn as one line, cost at one end and distinctiveness at the other, and a business is placed somewhere along it. More of one is then automatically less of the other, and the interesting question becomes where along the line a business sits.
The pair is not one line. There are two questions, each answered on its own, and neither answer constrains the other. Two questions answered yes or no produce four cells, and a classification must have as many cells as its tests produce. Count them: evidence on the cost side only, evidence on the buyer side only, evidence on both sides, evidence on neither. Four. The spectrum reading produces two ends and a middle. Two ends and a middle is not the same shape as four cells, and cannot be made into it by drawing more carefully.
Then place the case. Anjani Stationers sits in the fourth cell, evidence on neither, and that is where most businesses sit. The fourth cell is what makes the spectrum reading not merely imprecise but incapable of representing the ordinary case at all. A line running between two things has no position on it for a business that is at neither end and is not partway between them either. Such a business is off the line entirely. Whether an advantage a business turns out to have is the same thing as a strategy it announces is a separate distinction and is set out under The Sources of Competitive Advantage.
Back to the office gate one last time. The three cells that matter are all standing on the same pavement. Nobody at any of the three stalls picked a strategy off a list. One of them found out, by taking a crate every morning, that it could buy milk at a rate the others had never been quoted. Another found out that its customers had stopped deciding where to go. And a third, doing perfectly good business, found out neither of those things about itself. Finding out neither is not a failure and is simply what most stalls are like.
Two questions are asked of one business and each is answered yes or no. Before reading on, how many possible outcomes does that produce?
The mistake: scoring both columns on one scale
The scoring sheet is not built by a careless person. A careful one builds it, doing something that looks entirely reasonable, and the reasonable look is precisely why it survives review. The analyst rules two columns on a sheet, heads them cost leadership and differentiation, puts a business in each row, scores both columns, and reads the higher column as the strategy the business is following.
Run it on Anjani Stationers and watch the sheet fill unevenly. The cost column takes 70.42 per cent, then Rs 210.00/- a ream, then the Rs 7,50,000/- ceiling at 18.07 per cent of operating profit, then the 20.00 per cent of volume struck at the better rate. Four entries, all countable. The buyer column takes one thing, eleven years. A score is a quantity and a duration is not one, so to score the two together that eleven has to become a quantity.
So name what the sheet actually did. To add two things measured in different things, the sheet made up a unit. And now the part worth sitting with. The damage lands in a specific and repeatable direction rather than randomly. The column that accounting counts wins by construction. Rupees and percentages are what a set of accounts records, so cost evidence turns up already denominated in both. Buyer evidence turns up as a fact about a decision somebody made. Put the two into a scoring frame and the first one always has more to say, for every business, whatever happens to be true about any of them.
The sheet's regularity is then read as a finding. The analyst notices that most businesses seem to be competing on cost, and takes it for a fact about the world rather than a fact about the sheet. The two columns were never on one scale to begin with, so the fix is not a better weighting and not more careful scoring. Report which question each item of evidence answers, and stop there, rather than scoring both and comparing the scores.
An analyst scores a business on two columns, cost leadership and differentiation, and reads the higher column as its strategy. Anjani Stationers' cost column holds 70.42 per cent, Rs 210.00/- and Rs 7,50,000/-, and its buyer column holds eleven years. What has the table done?
Why can only one side of the comparison be moved?
Moving one figure and watching another figure move is how a relationship stops being a sentence and becomes something a reader can handle. The two questions do not admit of that treatment.
A control can only move a side that has a number on it. The cost side is the one holding rates and quantities, so any control would move the cost side. The buyer side of Anjani Stationers is an eleven year relationship and a spring order book, with no axis to slide along at all. A control would commit the scoring sheet's failure in interactive form, asserting through its dials that the countable side is the real side.
Name the evidence. Name which question it answers. Then stop.
The card below is the whole of the practitioner method, and it is short because the method is short. The third line is what makes it usable, and most people leave it off.
What would actually be written down about a business?
Consider a lender looking at a proposal, an analyst writing a short note, or a person deciding whether to put money into a cousin's workshop. The two questions give a card, and the card has three lines rather than two. Line one is the cost question: what rate does this business pay, or what does its works convert, and against whom is that being compared? Line two is the buyer question: what has a buyer actually done, and against what other supplier's buyers is that being compared? Line three is what gets written when the honest answer to either is nothing.
Run it on the case and the card fills like this. Cost question: Rs 210.00/- a ream paid, 70.42 per cent converted, compared against its own works and against no competitor, so nothing is established. Buyer question: eleven years of continuous buying and a book that refills each spring, compared against nobody, so nothing is established there either. Two lines, two honest blanks where a gap would go.
A card with two empty answers is a completed card and not an unfinished one. The sentence changes how people use the card. The temptation, once a card looks empty, is to keep digging until something goes in a box, and what comes back from that digging is usually a figure with no comparator dressed up as a finding. The blank is the result. Write it down, date it, and move on to what the business actually needs deciding.
Both questions are run over a business and nothing can be pointed at that establishes a gap on either side. What goes on the card?
What the currency and the legal form here do and do not establish
Two things in the case are local to India and nothing else is. The money is written in rupees with the lakh and crore grouping, so Rs 1,57,50,000/- reads as one crore fifty seven lakh fifty thousand, and Private Limited is an Indian legal form. Neither of those changes the argument. Which of two questions an item of evidence answers is not a jurisdictional matter anywhere, and a business in any country with any legal form faces the same two questions and the same problem of putting them on one scale.
The two questions need no rate, threshold, filing requirement or period from any jurisdiction, and what the Private Limited form itself requires of a business is a matter of company law rather than of strategy.
The two questions border several subjects that are set out elsewhere. The two strategies are defined at length, and the others counted out beside them, under The Sources of Competitive Advantage. The conversion yield is built, and what its shortfall costs in paper worked out, under Throughput. How a buying rate is struck, and why a gap of that kind is a ceiling rather than a saving, is argued under Procurement. Whether a name is worth anything on its own is tested under Brand Equity. Reading a customer list for dependence is set out under How to Analyse Customer Concentration and Dependence. How a fixed cost spreads over more units is set out under Economies of Scale and Scope Compared. And whether either advantage would still be there next year is a separate subject.
Where do the two names come from?
| Source | Document | Site |
|---|---|---|
| Michael Porter | Competitive Strategy: Techniques for Analyzing Industries and Competitors, 1980 | the catalogue listing kept by the book's publisher, or any university library catalogue that carries the author |
| Anjani Stationers Private Limited | the year two trading figures and the paper buying record, as built under Throughput and Procurement | no publisher; an invented case |
Anjani Stationers Private Limited and the Sunrise Public School group are invented.
Educational material. Not advice on any investment, tax, budget or market position.