Competitive Strategy for Software Start-ups

The rules of competitive strategy state that all competitive strategies must fall into one of four categories:

Cost Leader

Differentiation Leader

Cost Focus

Differentiation Focus

Value can be defined as the sum of the cost of a product and the cost benefit of the differentiation it provides.

A cost leader has the product with the lowest acquisition cost. Market structure will determine how difficult it is to maintain a cost leadership position. If, for example, the competition is fierce and the cost of raw materials or production is high this will keep profit margins low and make maintaining a cost leadership position extremely difficult. However, if a company is able to design a more efficient distribution or assembly mechanism, they can quickly turn the tide in their favor and become the cost leader (for example, Henry Ford’s assembly line). Because of market forces, success as a cost leader usually requires being the sole cost leader, not one of many cost leaders.

Differentiation leaders generally have higher prices, but provide value through extras features that are not found in the lower cost solutions. It is important to note that differentiation itself does not guarantee success, nor will the value generated by a differentiation leader be the same for each customer. Indeed, in many cases, the value provided by differentiation may be non-existent, because the features or add-ons are not required by the customer (for example, adding AD integration to your product only adds value if the customer is using AD). For this reason, many markets can have both cost and differentiation leaders who are extremely profitable.

Cost focus and differentiation focus are two variants of the same generic strategy. A cost focus leader has the lowest acquisition price for a target segment of the market. A differentiation focus leader extends its products with extras that meet the needs of a target segment of the market. The key requirement is that there must be a significant difference in the needs of these specialized market segments. If a there is not significant specialization by different groups in the market, a cost focus or differentiation focus leader cannot provide enough value in comparison to the cost or differentiation leaders and will be restricted to mediocre profits.

It most markets, it is nearly impossible to be both a cost and differentiation leader. However, there are exceptions. If a market has few competitors or a company can control a significant percentage of the market, then it is possible to be both a cost and differentiation leader. This, of course, is how Microsoft came to dominate the software industry. At the time when Microsoft entered the market, it had few competitors. This allowed Microsoft to quickly gain a significant market share, which in turn, has enabled it to maintain both its cost leadership position and its differentiation position to this day.

Linux presents a significant threat to Microsoft’s dominance, because it undermines the cost leadership position that Microsoft has enjoyed for so long. As a result, Microsoft has been forced to resign its cost leadership position and focus on differentiation (hence, we get the term “total cost of ownership,” which is decidedly rooted in differentiation).

Because of the significant growth of the open source software movement, most commercial software companies can no longer succeed as the cost leader in their field. This leaves three viable strategies, two of which are more attractive long term (the cost focus strategy is attractive short term, but cannot be guaranteed long term because eventually an open source cost focus equivalent will appear if that focus begins to capture a significant market share).

If you are in charge of planning a commercial software company’s competitive strategy, and your company is not working on anything amazingly new or cutting edge, you should strongly consider a differentiation focus or differentiation strategy. If you work for a start-up, however, you are really restricted to cost focus or differentiation focus in the short term, because the cost leadership and differentiation leadership positions will most likely be already taken by established competitors (ie. open source and Microsoft). In the long term, all start-ups should consider transitioning to a differentiation focus strategy (or, if they are really ballsy, a differentiation strategy) for the reasons mentioned previously.

4 Comments

  • Porter drew the differences between cost and differentiation focus for some reason, but I never really liked it. Every product is differentiated by some product attribute, one of which is price. The key in all instances is the ability to create customer value faster than your costs increase.



    For Wal-Mart this is cost. Their size and technology prowess allow them to charge less and still make more money, just like Dell. For all the other retailers, you have to figure out something different. Thus Target is seen as a "more upscale" Wal-Mart, and charges a premium for that image.

  • I assume this is why Porter takes special care in noting that the two are actually just seperate instances of the same generic strategy. In any case, they are slightly different, because cost focus has very specific boundaries (you can't go below a fixed cost and still be profitable) when compared to differentiation focus.

  • Ah, but you can go below what people traditionally consider a fixed cost. Let's take Wal-Mart for example. Retailers normally consider the carrying costs for inventory a fixed cost of doing business.



    Want to know what Wal-Mart's inventory carrying costs are? No, not close to zero. Negative! If you're a consumer goods supplier, such as Proctor and Gamble, Wal-Mart will *not* pay you until your products have been sold and they've already collected. So instead of carrying costs, they have carrying profits, to the tune of several million dollars per year, from the float on the money they have in hand before they pay you!



    Who says you can't go below a fixed cost? It's all in how you work it. Also, do you know which company has done better over the past 20+ years, Microsoft or Wal-Mart? If Sam Walton had not died and his Wal-Mart shares been split among his family, he would be richer than Bill Gates.

  • First off, Wal-Mart is an exception to the norm. Most industries would find requests like that to be obsurd. It is only because Wal-Mart captured such a high market share that it was able to change the rules of the industry. To capture that market share in the first place; however, it had to play by the rules. Secondly, Wal-Mart still has a fixed cost that it cannot go below, they have to pay the suppliers eventually, so even if they "float" the cost, they are still paying out (if there was really no cost involved for acquisition, they could sell everything for 1 cent and never lose a dime). Then, they also have to consider the price of stocking the shelves (manual labor), etc. which is relatively fixed as well. As well as building stores, etc. There is definately a fixed cost that they cannot go below and still be profitable. Thirdly, Wal-Mart doesn't even fall into the cost focus category anyway, so it doesn't really help to bring them up as an example.



    Either way, the two strategies are very similar, both target a narrow audience and focus on creating enough value to win the customers in that segment while making a profit, but they are dissimilar in that one has the goal of reducing the costs, while the other has the goal of maximizing the feature set. This is not to say that you will not always want to reduce costs or that you will not always want to offer your customers more features, but having a primary goal is definately a good thing and the two strategies definately have very different primary goals, even if the end result may be similar.

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