What gives a business a competitive advantage?

There are many ways for a business to develop a competitive advantage that will enable it to outgrow and outlast its competitors. If a company has an economic moat it can solidify its place in the market relative to competitors, build a brand in the mind of customers to make them obsess over the company’s products and profit from growth trends.

The most important thing for a company to concentrate on is effectively positioning themselves in relation to their competition. Michael Porter (1980) showed that there are three main generic strategies which firms can utilize to build their competitive advantage:

  • Overall cost leadership: This involves targeting customers, based on offering them the lowest possible price. For this strategy to be effective a company must have a sustainable cost advantage and economies of scale which enables it to maintain its position as a cost-leader in the marketplace. Firms pursuing cost leadership often have generic products and highly efficient distribution networks to maximise efficiency.
  • Differentiation: This involves winning customers through factors other than price such as a higher product quality or superior service. To effectively pursue a differentiation strategy, a firm must differentiate itself favourably compared to its
    competition. Firms pursuing a differentiation strategy seek to match their competition in areas which do not differentiate it and provide a superior offering in the areas they differ.
  • Focus: A firm seeks to focus on just a few very specific segments of the industry. This may involve specialised ‘know-how’ or offering a particular service which competitors do not offer. Focus involves concentrating on winning a smaller number
    of customers but creating an excellent ‘value proposition’ which makes the firm dominant in its niche.

Quality vs Quantity

Porter tells us that a firm does not need to have a high market share to maximise profitability. In fact, many firms who have a small market share have very high levels of profitability as they focused on targeting a small and profitable sector of the market.

On the flip side, Porter reflects that firms who fail to position themselves effectively in the marketplace can essentially become ‘stuck in the middle’ and are vulnerable to attacks from the competition who targets specific characteristics of the target market and provide a superior offering.

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Motley Fool contributor Marcello Pinto has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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