Differentiate or die!

Differentiation and the smaller business

In this month’s obk mba class we have been looking at differentiation as a competitive strategy. Competitive strategy is concerned with outperforming the competition. It is therefore concerned with relative performance rather than absolute performance. Performance in most mature, fragmented industries tends to be normally distributed with a disproportionate number of businesses performing around average (which is often quite poor!) figure 1.

Figure 1 Relative performance
 

 

Following extensive research, author and speaker Michael Porter concluded that to outperform rivals you needed to do one of two things.   Relative to your competition, you either have to have a lower cost structure (a cost leadership strategy) or you need to command a price premium (a differentiation strategy). For a cost leadership strategy to translate into superior performance the business cannot pass on all their cost savings in lower prices to the customer. Similarly a differentiation strategy will only translate into superior performance if the price premium isn’t all swallowed up by higher costs.

Cost leadership is about having a lower cost structure rather than just having lower costs. Small businesses may have lower costs than big businesses but emulate the costs of bigger businesses when they grow. Most small businesses don’t have a lower cost structure than their competition. They compete in the same labour market, pay the same for accommodation and buy their stationery at the same price as their competitors. Unless they have a unique product or proprietary technology it is difficult for most small businesses to pursue a long term cost leadership strategy.

That leaves differentiation. Differentiation means choosing to charge customers more than the competition. Customers will only pay a price premium if they receive superior benefits. All businesses compete on value and value for this purpose I’m going to define as:

Value =     Benefits

Price paid

Customers seeking superior value will only pay a higher price if they receive superior benefits. Customers receive benefits when their needs are better met. Customers have differing needs. Not everybody is going to derive the same benefits and not everybody will be willing to pay the same price. For smaller businesses pursuing a differentiation strategy this will also mean having a focused strategy (see a previous blog of ours ‘Just Say No’). This involves dealing with a subset of the market place. This means seeking to please a specific group of customers with particular needs rather than trying to be all things to all people. Indeed it usually means not being able to meet the needs of some potential customers who then choose your competitors. But this is good! To successfully execute a differentiation strategy a business must meet the needs of some customers better than the competition and must command a price premium for doing so.

But what are these needs and how can they be better met?

Rarely do customers understand their own needs and often make buying decisions they find difficult to explain.  As Dan Ariely explains in his superb book Predictably Irrational “…we really don’t know our own preferences that well.” But as Steve Jobs once said, “It is not the customer’s job to know what they want.”
Many years ago the late Peter Drucker wrote, “The customer rarely buys what the company thinks it sells him. One reason for this is, of course, that nobody pays for a ‘product.’ What is paid for is satisfaction, the meeting of a need.” You may think you are selling a product or a service, but in reality your customers merely hire your products or services to “get a job done in their lives.” As Ted Levitt wrote in a famous Harvard Business Review article Marketing Myopia, “People don’t want quarter-inch drills—they want quarter-inch holes.”

Clayton Christiansen explains this idea in this video:

So what is the key to a successful differentiation strategy?

The answer lies as much in psychology as it does in economics. Our needs are more subtle and esoteric than we realise. Yes we look for the utility value that comes with the product or the service we are seeking to buy but we have other less obvious needs, like the need to know we have made the right decision, the need to avoid future embarrassment or the need to feel liked.   In many cases we don’t understand enough about the underlying product or service on offer to make an informed judgement, (think car service or legal services) so we make decisions around the bits we do understand and make assumptions around the rest (see forthcoming blog “Is being good, good enough?”). Rory Sutherland calls this affirmation bias while others the “halo” effect.

How you pursue your differentiation strategy is step 2. Step 1 is understanding the need to do so. Porter presented us with a stark choice; if you want to do better than the rest it’s either cost leadership or differentiation. For the vast majority of small businesses cost leadership is inaccessible – and that leaves differentiation. So for many the choice is simple. As author Jack Trout put it on the cover of his best selling book, “Differentiate or die”.

We’d really appreciate your contribution so please do add your thoughts using the comments box below.