Differentiation and it's role in Competitive Advantage

May 22, 2013

Table of contents:

1. What is it
2. Buyer value
3. The buyer’s perception of value
4. Buyer purchasing criteria
5. How to lower Buyer Cost
6. How to raise Buyer Performance
7. Sustaining Differentiation
8. How to create differentiation
9. Pitfalls to avoid
10. Conclusion

In order to create a successful product you have to be acutely aware of how you will gain competitive advantage within the market. Competitive advantage creates opportunity for new products to disrupt incumbent industries and it helps create a moat of defence against the onslaught of competition.

However, it seems that the differentiation strategy of a lot of products seems to not have been given a second thought. When you don’t have a clear strategy for competitive advantage you end up with a product that is stuck in the middle ground of mediocracy. Mediocre products built for the mass market return less than average results and are in a precarious position if a new competitor were to enter the market.

In this post I will be looking at differentiation, how it is perceived by consumers, the different types of differentiation and how you can create differentiation for your product.

What is it

There are essentially two strategies for creating competitive advantage. Cost Leadership and Differentiation. In this post I’m going to be focusing on differentiation, but it is important to understand why differentiation is a strategy and how it relates to competitive advantage.

Cost Leader

A Cost Leader is where the company has decided to create the cheapest product on the market. This strategy requires the product to be commoditised and take advantage of the economies of large scale. Usually there can only be one Cost Leader within an industry. When you choose the Cost Leader strategy, you must ensure that your product meets the minimum requirements of the market. If your product does not meet these requirements, you will be forced to drop your prices even lower.

Differentiation

The Differentiation strategy is where a company decides to choose a certain attribute of the product to focus on. In order to make this strategy work you have to select an attribute that a big enough section of the market care about enough in order to pay a premium price for your product.

Unlike the Cost Leadership strategy, the Differentiation strategy allows multiple products to co-exist as long as they concentrate on different attributes.

In order to make the Differentiation strategy work, you must ensure that the premium price you are able to charge is enough to cover your costs of focusing on the chosen attribute. If the attribute you choose to focus on is not valued highly enough by the market, you will end up with below average returns.

Buyer value

However creating a “unique” product by choosing an attribute to focus on won’t always produce a competitive advantage through differentiation. If the buyer does not value what you are differentiating on, you still won’t create a successful product. You also need to create a product that can command a price that exceeds the extra cost of creating that premium product.

In order to create a product that is wanted by the market, you need to analyse the Buyer Value chain. The value chain is basically how the product will be used by the person who buys it and what job it is required to do. For example, a car might be used to commute to work, but it also might be used as a sense of pride and achievement within a social circle.

A company is able to create value for the buyer by either lowering the buyer cost or raising the buyer performance.

Lowering buyer costs

A product is able to lower the buyer’s cost in many different ways. For example, a particular model of car might be more convenient, more reliable or cheaper to run. For consumer based products, there are many different ways that a product can reduce buyer cost, and many of them don’t involve financial costs at all. When a product is able to reduce frustration or make it easier to use, it makes it more attractive to a consumer.

Raising the buyer performance

Raising the buyer performance is where you create a product that exceeds the buyer’s minimum requirements or level of satisfaction. For example, raising the amount of milage a car can achieve or raising the quality of the interior are two ways you could raise the buyer performance of a car. Raising buyer performance is often just as much about prestige and status as it is about features or quality.

The buyer’s perception of value

One of the problems with choosing a differentiation strategy is the buyer’s perception of value. It’s often difficult to appreciate the true value of something before you buy it. This is especially the case when you are a first time buyer, or you lack industry knowledge or experience of using the product for yourself.

This is a problem because if you differentiate on a certain quality, but that quality is perceived at a different level of importance by the consumer, you will have difficulty creating competitive advantage.

A common case of the problem of buyer’s perception of value is when a buyer will look at the initial price of a product, without factoring in maintenance, reliability, durability or any other such characteristics that will have an impact on the total cost of the product over it’s lifetime. It can also be difficult to judge the comfort or reliability of a product at the outset because these characteristics can only be judged after constant and extended usage.

The problem of the buyer’s perception of value is an opportunity to educate the buyer on your chosen differentiation strategy and how your product is significantly better than what else is on the market. You need to signal the true value of your product and your company. Signalling is derived from the brand perception and reputation you have built up as well as how you deal with customers and their experience of you as a company.

It is also important to consider that the buyer and the user are often not the same person. A buyer who is responsible for making purchasing decisions within a company will usually want to optimise for price, whereas the user will want to optimise for usability or reliability. Differentiating on usability is all well and good, but it will be a wasted opportunity if the actual buyer only cares about price. This is also important when you consider your signalling strategy. The person responsible for making purchasing decisions will probably be impressed with glossy brochures and marketing material, whilst the technical personal will be impressed with a totally different set of characteristics.

Buyer purchasing criteria

Once you understand the buyer’s perception of value, you can begin to create criteria that are important for a buyer to make a purchase. Buyer purchasing criteria basically breaks down into Use Criteria and Signalling Criteria.

Use Criteria

Use Criteria are the tangible aspects of a product such as product features, reliability and quality. Use Criteria are essentially how the product either lowers the buyer’s cost or raises the buyer’s performance. When thinking about the Use Criteria of your product, you need to consider not just the physical attributes and qualities of the product, but also how it is delivered, used and maintained for it’s entire lifecycle with the buyer.

Whilst it’s easy to think of the tangible aspects of Use Criteria as the physical attributes and features of the product and how it is used, the intangible aspects also form an important part of the decision making process. Aspects like the style, design and prestige of using a product are also important criteria to consider. Usually brands will have a very specific reputation and there are usually perceived biases and brand connotations with purchasing certain products over others. These are all important Use Criteria to consider.

Signalling Criteria

Signalling Criteria is the perception of value through signals. This could be through advertising and marketing, brand reputation, word of mouth or simply how you treat your customers and what kind of experience they have with you.

Signalling Criteria can be extremely subtle and difficult to understand. It can often be difficult to understand why a buyer will choose one product over the other when the products are almost identical. Often it will because of the buyer’s biases that have been built up through signalling.

Signalling Criteria is at it’s most importance when the buyer is not very experienced in purchasing the product in question. As I mentioned above, the problem of the buyer’s perception of value means that the buyer doesn’t understand the difference between good and bad products and doesn’t appreciate the characteristics that differentiate a certain product.

Signalling is important in this case because it makes the decision easier. For example, when you are buying your first high-end camera, it can be difficult to understand every attribute of the specifications and how that will impact your usage of the product. Companies like Cannon have created immense signalling exposure around their range of cameras so amateur photographers are already familiar with their products and will naturally gravitate towards them because they perceive it as a safe choice.

The importance of satisfying both Use and Signalling Criteria

It is important to understand how your product is able to satisfy both Use Criteria and Signalling Criteria. If you are not able to satisfy both, you will struggle to gain traction. For example, if you can satisfy Use Criteria, but you can’t attract customers because you haven’t thought about Signalling Criteria you will fail. Similarly, if you are able to satisfy Signalling Criteria without Use Criteria, your customers will soon realise your product is not all that.

How to lower Buyer Cost

There are many ways to lower the buyer’s cost in order to achieve differentiation. The most important thing to remember is that you should aim to lower the total cost for the buyer in using your product to solve their problem, and not just the direct cost of your product.

For example, you could extend into complementary products or services that are also required by the buyer in order to use your product. By allowing the buyer to purchase from one company instead of many, you reduce the complications of making the purchase decision and they feel more confident that they are making the right purchase because all of the components will work together. This can also significantly reduce the fear of making the wrong decision if something was to break. By centralising the customer support and technical enquiries, you can reduce the mental fatigue of making the purchase decision.

How to raise Buyer Performance

Raising the buyer’s performance relies on a deep understanding of how your target market uses your product and how they derive value.

For example, a car aimed at a young family with small children will appreciate a car that differentiates itself by providing additional storage capacity, child safe interior and excellent value for money.

On the other hand, a car aimed at a young professional will aim to raise the buyer’s performance through the prestige and style of owning such a luxurious car.

Sustaining Differentiation

Nothing lasts forever, and never has this been more true than in a strategy based on differentiation. There are many ways that your competitive advantage derived through differentiation can be eroded, and so you need to ensure you are acutely aware of your company’s position.

For example, whilst you might be solving an important problem for a specific segment of the market, that problem might eventually go away. This is often the case when two adjacent technologies converge and therefore render your product obsolete.

On the other hand, a competitor might look at your company and try to leap frog the characteristics that you are differentiating on by going further or moving the emphasis on to a slightly different attribute of the product.

In either case, it is critical that you understand the sources of your differentiation and the following conditions:

Sources of differentiation that involve barriers to entry If you choose a differentiation strategy that does not involve barriers to entry you are a sitting duck waiting to be exposed. There should be some sort of advantage that you have over the market that means new entrants cannot simply imitate what you are doing. This could mean propriety technology, invested consumers or simply brand recognition. However, it is important to know that any barriers to entry that are based on signalling criteria are still considerably vulnerable.

You have a cost advantage Ideally you should have a cost advantage in creating your differentiated product. This could be in-house expertise or strong capabilities in distribution or marketing that are not easily replicated. If you don’t have a significant cost advantage, competitors can quickly start to imitate you.

Multiple sources of differentiation If your whole value proposition is based around a single characteristic of differentiation, you are leaving yourself extremely exposed to competitors. Ideally, there should be many ways that you are differentiated and that present significant opportunities to gain competitive advantage.

For example, if your only differentiating characteristic is exquisite design, it is not very hard to replicate and replace you. However, if you have many forms of differentiation, such as the exquisite design and user experience of multiple related products and services, you are in a much more defensible position.

You create switching costs as you differentiate Switching costs are a well known way of achieving competitive advantage. If your customers are invested in your product, it makes it less attractive to change to a competitors product.

Switching costs should be created through the natural process of customer usage and should be focused on the ways that your product and your company are unique.

How to create differentiation

There are many ways to create a product that is based upon differentiation. Here are the important first steps to take when considering this strategy.

Pinpoint who the buyer is

The first critical step is that you must pinpoint who the actual buyer of the product is. You can’t begin to start to analyse the Use or Signalling Criteria until you fully understand who is actually going to be buying the product.

Making assumptions at this stage can mean that you end up following the completely wrong path trying to target someone that will never buy your product.

Understand how the buyer uses your product

In order to find opportunities for differentiation, you need to understand intimately how your product is used by your target audience. If you can find areas where the current market offerings are underserving a specific use case, you can find an opportunity for differentiation.

This not only means how the buyer physically uses the product, but also how it is delivered, maintained and how it fits in with the rest of the buyer’s life or workflow. There are many ways to differentiate that extend past the physically qualities of a product.

Lean in on your company’s natural advantages

It’s easy to look at competitors or companies in other industries and try to replicate the sources of differentiation that have made them successful. However, this is likely going to be unsuccessful for you because you probably don’t posses the same natural qualities that those companies have.

There is no point in trying to differentiate on design if you don’t have in-house world class designers. Similarly, if your expertise lies in the unsexy logistical nature of distribution, don’t neglect it just because it isn’t prestigious.

You need to focus on your unique strengths as a company.

Find cost effective ways of differentiation

As I mentioned above, in order to sustain differentiation, it needs to be cost effective. There is no point in trying to execute on a strategy that won’t make significant profit and has no margin because it will not be sustainable.

Again, try to find unique methods of differentiation that you as a company can cost effectively pursue. Certain methods of differentiation aren’t costly and can actually reduce your overall costs.

Combine multiple forms of differentiation for the biggest impact

Again, as mentioned above, in order to ensure that differentiation is sustainable, you need to combine multiple forms of differentiation together. Try to find a configuration that has the biggest impact on the value that is derived by the buyer.

For example, target a specific customer with a specific problem and find multiple ways that differentiate your product to meet that customers requirements and desires.

Build high barriers of differentiation

If you get too caught up in believing your own hype, you won’t see the signs of when the market no longer values what you are differentiating on. When this is the case, the sustainability of your competitive advantage will be eroded.

You need to ensure that you can maintain and grow your defensibility and that you are not leaving yourself exposed to new entrants.

Slash unwanted features and costs

In order to make a differentiation strategy work, you need to focus on specific attributes and cut everything else. Just because your competitors offer certain features, does not mean that you have to too. This will make your product bloated and costly.

Focus on the specific attributes that you are differentiating on and nothing else. Cut any costs that aren’t directly related to those attributes and get rid of any additional features that do not contribute to the differentiation.

Although you are offering a premium product, you still need to be aware of how you can dramatically reduce certain costs.

Pitfalls to avoid

Of course, differentiation is not without its pitfalls. Here are 7 things that you need to avoid.

1. Uniqueness that is not very valuable

Just because something is unique doesn’t mean that is has a higher value. Focusing on a characteristic that is either unwanted or not able to be perceived by the buyer will be a waste of time and money.

2. Diminishing returns of differentiation

You might start off with a clear strategy to offer the very best customer service in the industry. This is a good strategy to pursue, but at some point it will hit the law of diminishing returns. Once you become too differentiated, you leave yourself exposed to a competitor that can offer the right level of differentiation at a lower cost.

3. Too expensive

Differentiation allows you to charge higher prices because customers are willing to pay more for products that better suit their needs. However, if you charge too much for your differentiated product, you customers will quickly find an alternative.

4. Ignoring Signalling Criteria

Many companies refuse to invest in marketing or advertising because they believe their superior product is enough to attract significant buyers. However, if you are selling to inexperienced customers or buyers that don’t understand the difference in value of one product from another, you leave yourself exposed to a company that offers a product that is lower value but has a better understand of signalling.

5. Not understanding costs

Differentiation often requires that you invest heavily in the areas that you are looking to set yourself apart. However, if you don’t fully understand how your direct costs, the price you are able to charge and the buyer’s perceived value are all interrelated you will not be able to create sustainable differentiation.

6. Focusing too much on the product and not the bigger picture

A company that is focusing on creating a differentiated product will usually focus too much on their own physical product and not enough on the bigger picture of how that product fits into the world. There are many ways to differentiate a product, a lot of which aren’t directly tied to the product at all. It’s important that you fully understand how your product fits into the larger ecosystem.

7. Not understanding the customer

And finally, if you don’t fully understand who you are selling to, their problems and what they value in your product, you will end up creating a product that isn’t really differentiated at all. This leaves you exposed to competitors who actually do understand the market and can focus on meeting the specific requirements of the customer.

Conclusion

Phew, that was a long post! Thank you for sticking with me.

As you can see, there is quite a bit to understand when creating a product through differentiation. I feel many products don’t really understand the nuances and therefore are leaving themselves open to being stuck in the middle ground of death.

Once you understand differentiation you begin to not only be able to see products and companies that clearly don’t understand it but also the opportunities that are present for creating new products to disrupt incumbent industries.