What is competitive advantage?
Competitive advantage is the favorable position an organization seeks to be more profitable than its rivals. To gain and maintain a competitive advantage, an organization must demonstrate a greater comparative or differential value than its competitors and convey that information to its desired target market. For example, if a company advertises a product for a price that's lower than a similar product from a competitor, that company is likely to have a competitive advantage. The same is true if the advertised product costs more but offers unique features that customers are willing to pay for.
In the 1980s, professor Michael Porter at the Harvard Business School looked at successful businesses and created a framework for how leaders could think strategically about beating the competition. Porter suggested that companies analyze five important criteria, which Porter called the Five Forces, to gain an understanding for the competitive landscape. Once achieved, he recommended the use of three generic strategies to help leadership make the best choice about which type of competitive advantage they should pursue.
Porter's Five Forces is an alternate model to SWOT (Strengths, Weaknesses, Opportunities, Threats), an analysis tool credited to Albert Humphrey at the Stanford Research Institute to help companies get a sense of their position within a competitive landscape. Porter taught his students at Harvard about SWOT analysis but felt the tool had limitations because it placed too much focus on individual companies rather than on industries. Porter saw the need for a framework that also looked at the competitive landscape holistically, in the context of an entire industry. The simple framework that Porter developed for achieving a competitive advantage in the marketplace is still being taught in business schools today.
Porter's techniques for analyzing competitors
In his 1980 book Competitive Strategy: Techniques for Analyzing Industries and Competitors, Porter maintains that the appeal of a market segment is determined by the following five competitive forces:
- Threat of new entrants. How easy is it for a new competitor to enter the market?
- Rivalry among existing competitors. How many competitors offer a similar product at a similar price?
- Threat of substitute products or services. What is the likelihood a customer will switch to a similar product?
- Power of buyers. How easy is it for buyers to drive prices down?
- Power of suppliers. How easy it is for suppliers to drive prices up?
The first three forces are sometimes referred to as horizontal competition. Variables in horizontal competition include the possibility of new competitors entering the market, the rivalry among existing competitors, and the threat posed by substitute products or services.
The last two forces are sometimes referred to as vertical competition. Vertical competition is dependent upon supply chain; the price of raw materials; the cost of labor; and the customer's relationship with a product, brand or company.
Porter's techniques for creating superior performance
In his 1985 book Competitive Advantage: Creating and Sustaining Superior Performance, Porter proposed that once the potential for profitability in a market is established, the next step toward gaining a competitive advantage is to decide whether to use a low-cost approach or a differentiation approach. Once an organization decides between the two, a third element that Porter called focus needs to be made certain. This part of the framework identifies who the product or service should be marketed to. These techniques include the following:
- Cost leadership strategy. Should the product or service be offered at a lower price than the competitors?
- Differentiation strategy. Should the product or service have unique features or benefits that are so appealing that customers are willing to pay a premium price?
- Focus strategy. Should the product or service target niche markets that are overlooked or underserved by competitors?
Porter also looked at competitive strategies from a long-term, sustainable angle and maintained that creating a sustainable competitive advantage not only boosts a company's image in the marketplace but also affects valuation and the potential for future earnings.
How to create a sustainable competitive advantage
Sustainable competitive advantage refers to maintaining a favorable position over the long term, which can boost a company's image in the marketplace, its valuation and its future earning potential.
Strategic management expert Jay B. Barney published an article in 1991 that took Porter's ideas and expanded upon them, adding an element for sustaining a competitive advantage over time. Barney's article, titled "Firm Resources and Sustained Competitive Advantage," suggested that instead of just looking at outside influences when analyzing the competitive landscape, companies should also look inward to achieve sustainable competitive advantage.
Barney wrote that previous frameworks, including Porter's, were based on the incorrect assumption that all companies within the same industry shared the same attributes. It is each company's differences, Barney pointed out, that should be exploited to gain a competitive advantage.
Resource-based view and VRIN
Barney proposed using a framework called the resource-based view (RBV). This competitive advantage framework places emphasis on a company's core competencies as well as the combination of skills and resources that make a company unique compared to the competition.
Barney maintained that for resources to hold potential as sources of sustainable competitive advantage, they should be valuable, rare, inimitable and non-substitutable (VRIN), defined as the following:
- Valuable. Does the resource have greater value, in terms of costs and benefits, than similar resources in competing companies?
- Rare. Is the resource scarce when compared to the relative demand for its use or what it produces?
- Inimitable. Can the resource be imitated or copied easily?
- Non-substitutable. How difficult is it to replace the resource with a substitute?
Barney categorized resources as either tangible or intangible. Tangible resources, such as technology, can be bought by other competitors to gain a competitive advantage. However, intangible resources, such as positive brand recognition, cannot be bought and are the main source of sustainable competitive advantage.
To leverage their core competencies, companies can start by identifying their key resources and then use the VRIN framework to determine if the resource is robust enough to provide sustainable competitive advantage.