Playing To Win

Can You Be Both Cost Leader & Differentiator?

Not if you Want to be Great over Time

Copyright: Roger L. Martin, 2021

The Playing to Win strategy question that I probably get most often is: why can’t we be both a cost leader and a differentiator? Given the question’s frequency, and the critical importance of the answer, I am going to provide a comprehensive answer in my 27th Playing to Win/Practitioner Insights piece on Can you be Both Cost Leader & Differentiator. (Links for the rest of the PTW/PI series can be found here.)

Why the Frequency of the Question?

I think I get the question as often as I do for two reasons. First is that in advising on strategy, I emphasize the need to choose and in general people don’t like to choose. People like more to keep options open rather than cut them off, which is one reason why most strategy isn’t strategy, it is planning. So, when I say one of the important strategy choices is to be either a cost leader or a differentiator, people tend react by challenging why they must choose.

Second, I am known as the Integrative Thinking guy, so they want to attempt to catch me being inconsistent by reminding me that when I talk about Integrative Thinking, I argue against making trade-offs but when I talk about strategy, I say you have to make a trade-off between being a cost leader or a differentiator. In fact, I don’t actually argue against making trade-offs. While I argue against making unpleasant trade-offs that leave you in a weak and vulnerable position, I am always in favor making choices that focus your efforts and investments in a way that enables you to win.

From Where did the Idea Come?

I certainly take zero credit for the insight about choosing between cost leadership and differentiation. That was Michael Porter in his landmark 1980 strategy book, Competitive Strategy. He pointed out that the greatest danger in strategy is to end up being stuck in the middle, neither a cost leader nor a differentiator, and that a company has to choose between being one or the other to avoid becoming stuck in the middle.

Despite Michael’s relative clarity, there are problematic confusions concerning both cost leadership and differentiation. In my experience, managers mistake being cost effective for being a cost leader. To be a cost leader, you have to configure yourself uniquely in order to achieve a cost position that is meaningfully lower than for any competitor. That is what leading means. You can’t be a ‘leader’ if you are in the middle of the pack. You are cost effective if your cost position puts you in the middle of the pack. The value of a cost advantage is that you can use it to gain share. The cost advantage enables you to lower price below the level competitors can in order to gain share from them, which illustrates the problem with being stuck in the middle. You can’t protect yourself from the cost leader (or differentiator for that matter).

Managers also confuse being different with being differentiated. You are a differentiator only if you are different in a way that compels customers to pay a meaningfully higher price for your product or service that that of an average competitor. That is, for your customer base, you can charge a meaningful price premium and still maintain a stable market share. And as with the cost leader, it puts you in a position to be able to gain market share by cutting your price premium, which makes your value proposition to customers even more attractive. Again, stuck in the middle competitors can’t protect their share from the advantaged player — this time the differentiator.

Is it Absolutely True that you can’t be Both?

No, it is not. Every monopolist is by definition a cost leader and a differentiator. It has the lowest cost because there is no competitor for whom costs could be lower, and it charges the highest price because there is no competitor in existence to charge a higher price. Those who create a new industry (or segment thereof) often stay the dominant player even after they lose their monopoly/near-monopoly. That would include IBM in mainframes, eBay in on-line marketplaces, and Google in search.

For a time, their dominance enables them to be both the cost leader and differentiator in their industry/segment. Their dominant scale enables them to spread fixed costs over a wider base to provide a cost advantage and enables them to use some of the funds from the cost advantage to differentiate still more, for example through greater advertising intensity or higher R&D spending. But the double advantage tends not to last because eventually competition arrives, and it attacks in ways that force the company to choose — or fade away.

For example, through the 1960s, IBM owned a near-monopoly in the mainframe computer business and as a result, became the most valuable company in the world as of 1967. But in the 1970s, its position was attacked by Cray Computers at the high end with mainframes that were more powerful than IBM’s, and Fujitsu and Hitachi at the low end with cheaply made IBM clones. IBM ceased to be either the cost leader or the differentiator. Instead of choosing one or the other, IBM let itself be stuck in the middle and arguably has been on a downward trajectory ever since (despite the fantasy story about its rebirth as a services powerhouse under Lou Gerstner, which illustrates the difference between being big and having advantage).

For eBay, in due course Craigslist entered at the low end and companies like Etsy entered in high-end niches. And even mighty Google now has to attempt to fend off Amazon and Facebook. Most are so used to being the cost leader and differentiator while they were dominant that they don’t choose, because they don’t believe that they must. Because they were the cost leader and differentiator, they think they can still be both.

Why is it so Hard to be Both?

In the face of competition, it is unrealistic to be both because cost leadership and differentiation take very different disciplines. A cost leader will choose standardization and will sacrifice non-conforming customers in order to maintain its meaningfully lower costs. Southwest Airlines co-founder and longtime CEO Herb Kelleher was famous for responding to letters from customers complaining that Southwest didn’t provide features that other carriers did (e.g., business class; advanced seat selection) by encouraging the customer to use the other carriers, happily sacrificing the non-conforming customer in order to protect the standardization of his model. Differentiators will pursue deep, holistic understanding of customers so that they can build the next increment of value into their product or service. They are always innovating and building the unique value and strength of their brand. Four Seasons Hotels and Resorts has spent the past sixty years deepening its understanding of guests in order to customize the guest experience and build the strongest brand in the luxury hotel space.

If you have exclusively crummy competitors, you can simultaneously be better than them at both. But if you have a Southwest in your industry, it is virtually impossible to figure out how to achieve lower costs than it while also investing in being the most differentiated player. Or if you have a Four Seasons in your industry, it is similarly impossible to figure out how to out-differentiate it while becoming the lowest cost player. You just end up stuck in the middle and being powerless to keep the differentiator(s) and cost leader in your industry from feasting on your current market share.

The only strategies that have produced consistent, long-run success are exceedingly choiceful in focusing on either differentiation or cost leadership. Differentiators like Four Seasons, Lego, Novo Nordisk and WestLaw have been on top of their industries for decades and show no signs of flagging. Cost leaders such as Southwest, Vanguard, and IKEA continue to have long term advantage. There is zero confusion over which strategy each is pursuing — and that is a key feature of their collective dominance in their chosen fields.

Practitioner Insights

Don’t waste your time thinking about being both a cost leader and a differentiator. Think instead about to which of these different paths you will commit and how to achieve cost leadership or differentiation in the space you have chosen to compete. If you are in the fortunate position of having created an industry or a distinct segment within one, use the opportunity while you are a monopoly or near-monopoly to choose which position you will defend when the competition does arrive. The likelihood of success is diminished if the thinking and work on how to outdo the cost position or differentiation of the new competitor(s) commences only after they enter and attack, as was the case for IBM.

However, if you choose differentiation, it doesn’t mean that you needn’t concern yourself with cost management. Likewise, if you choose cost leadership, it doesn’t mean that you needn’t worry about customer value. To get the competitive benefits of differentiation, a differentiator must manage costs thoughtfully and aggressively to achieve cost parity with (or at least close proximity to) the average competitors. Otherwise, the company will be the second column from the right in the chart above. It will have worked hard to create the differentiator’s price premium but done so with costs so high that it is as competitively vulnerable as the average players stuck in the middle. Similarly, a cost leader must manage the quality of its offering carefully to achieve value parity with (proximity to) the average competitors or it will end up in the second column from the left, signaling that while it has worked hard to achieve low-cost position, it did so only by deprecating the offering to the extent that it can only be sold at a substantial discount — once again a competitively weak position.

It is a tough enough task to win either on low cost or differentiation while achieving proximity on the other. Trying to win on both is simply a recipe for disappointment.

Professor Roger Martin is a writer, strategy advisor and in 2017 was named the #1 management thinker in world. He is also former Dean of the Rotman School.