Porter´s (1980) Generic Strategies, Performance and Risk

Table of Contents

1. Introduction

2. Theory and Hypotheses
2.1 Porter’s (1980) Generic Strategies and Performance
2.1.1 Cost Leadership
2.1.2 Differentiation
2.1.3 Focus
2.1.4 Competitive Advantage or Stuck in the Middle
2.1.5 Generic Strategies and Performance: Major Studies
2.2 Strategic Choice and Corporate Risk of Bankruptcy
2.2.1 Strategy Paradox
2.2.2 Risk and Return in Strategy Research
2.2.2.1 Positive Relationship between Risk and Return
2.2.2.2 The Bowman Paradox
2.2.2.3 No Free Lunch

3. Data and Method
3.1 The Dataset
3.2 Measurement of Performance and Variable Definition
3.3 Measurement of Risk and Variable definition
3.4 Main Variable
3.4.1 Control Variables
3.5 Methodology

4. Analysis and Results
4.1 Performance-related Results
4.1.1 Additional Findings
4.2 Risk-related Results
4.2.1 Additional Model and Findings

5. Discussion, Implications and Limitations
5.1 No Strategy Paradox
5.2 The Role of Cost Leadership
5.3 Management Implications
5.3.1 Scenario Planning
5.3.2 Real Options
5.4 Limitations

6. Conclusion

7. References

8. Appendix

LIST OF TABLES

Table 1: Most important Empirical Studies on Porter’s Generic Strategies

Table 2: Seven different Classes for Profit Margin

Table 3: Seven different Profit Margins

Table 4: Descriptive Output – Profit margin over Strategic Groups

Table 5: Regression Output – Profit Margin / Independent Variables

Table 6: Regression Output – Profit Margin / Independent Variables

Table 7: F-Tests – Groups of Strategies

Table 8: Regression Output - Profit Margin / Independent Variables if Innovative Firm

Table 9: Regression Output - Profit Margin / Independent Variables if Employees < 5

Table 10: Descriptive Output – Risk over Strategic Groups

Table 11: Regression Output – Risk over Strategic Group

Table 12: Regression Output – Risk over Strategic Groups

Table 13: F-Test – Porter Strategies and Stuck Strategies

Table 14: Regression Output – Employment Development over Strategies and Risk

Table 15: Regression Output – R&D Development over Strategies and Risk

LIST OF FIGURES

Figure 1: Porter’s Typology and Generic Strategies

Figure 2: The Relationship between Cumulative Volume of Production/Market Share and Return on Investment

Figure 3: Allocation of Profit Margins

Figure 4: Allocation of Strategies

Figure 5: Frequency Distribution – Strategic Choice / Profit Margin

1. Introduction

In the summer of 2006 the board of Volkswagen announced the withdrawal from the luxury class market in North America, due to unsatisfactory results with the Phaeton. The Phaeton is Volkswagen’s most prestigious project that should attack luxury carmakers as Mercedes or BMW. More importantly the Phaeton should upgrade Volkswagen as a brand, moving away from the image as a „people’s carmaker“ to a high-end carmaker for business people as well. Unfortunately the customers did not perceive Volkswagen as a producer of luxury class cars, even though tests have shown that the Phaeton could actually compete against Mercedes or BMW on a technical level. After drawing a balance the board decided to withdraw the Phaeton from the North American market. On the other hand there are also success stories within the car manufacturing industry. Porsche for example, is able to outperform its competitors by bringing products to the market that set high value on quality and status. Thereby Porsche became the most profitable carmaker in the world. The other extreme is Toyota. They outperform its competitors by bringing products to the market that are priced well below market average (anonymous^[1], 2005).

This case from the car manufacturing industry illustrates a good example, in order to introduce the reader to the complex topic of corporate strategy and strategic choice. Firms such as Porsche and Toyota lie at the edges of the strategic spectrum, whereas Volkswagen underperforms since several years, because their products neither appeal to quality-conscious nor price-sensitive customers. However Volkswagen is able to generate profits that defend its position as the biggest car manufacturer in Europe, although the firmcannotbe assigned to one of the extreme points in the strategic spectrum, as for example Porsche or Toyota. Apparently these three firms can be separated on behalf of their strategic choice. The question then ultimately arises, why firms choose a certain strategy? Why is Volkswagen not trying to compete on price with Toyota or trying to compete on outstanding products with Porsche? Certainly that is easier said than done, since definitions of successful strategies have not led to consensus yet in the academic world (De Wit and Meyer, 2004). Several researchers formed the foundation for successful corporate strategies. Among others Miles and Snow (1978) proposed defender, prospector, analyzer and reactor strategies that determine the success of a firm. Their typology has been implemented and formed the foundation for prospect and growth. Another typology that is widely discussed is from Tracy and Wiersema (1995), who identified three value disciplines that can function as a successful corporate strategy (operational excellence, product leadership, customer intimacy). March (1991) proposed a dichotomy between exploration and exploitation that a firm is facing and that corporate strategy is a result of allocating resources. Without going too much into detail, it is striking that these typologies have more similarities than differences, when having a closer look. Thus, cost efficiency is repeatedly identified as one corporate strategy, meaning that firms compete at a lower level of product performance, but at significantly lower prices. Another similarity among most typologies is focusing on innovation, differences in product features or performance levels. The rationale behind these similarities is because resources are not limitless and firms have to make a trade-off to find their position in the production possibility frontier (Raynor, 2007).

The study that is most acknowledged and best summarizes the possibilities a firm has with respect to strategic choice, is from Michael Porter (1980). He proposes three generic strategies that can lead to a competitive advantage in an industry: cost leadership, differentiation and focus strategies. All other strategies are hybrid strategies that are much more vulnerable to attacks on either flank of the production frontier. A pure cost player is able to underprice the hybrid competitor and differentiators lure away quality-conscious consumers from the hybrid competitor. Several academic studies confirm that this typology can be seen as a foundation for separating successful and unsuccessful firms on behalf of their strategic choice. All in all Porter advises firms to choose one of the three strategies for the long term, in order to stay competitive.

Coming back to the example above, Porter’s theory perfectly describes the success factors within the car manufacturing industry. Those firms that operate at the edges of the strategic spectrum (e.g. Porsche, Toyota) outperform those firms that have hybrid strategies (e.g. Volkswagen). Nevertheless Porter’s theory is less useful when asking about Volkswagen’s motivation to operate with a hybrid strategy. It is unlikely that the management of Volkswagen is not aware of the fact that their competitors are more successful with a pure strategy. What then drives firms to implement hybrid strategies, knowing that they are less successful?

Just recently Michael Raynor (2007) challenged Porter’s widely accepted typology, by including another dimension in the discussion that previously did not find consideration:risk. He claims that firms that execute pure strategies are much more exposed to corporate risk than firms that execute hybrid strategies. Two arguments support his view. First Porter’s and other studies include what is called a “survivor bias”, meaning that firms that went bankrupt during the investigation (with a pure strategy) do not play a role in the analysis. Second firms that have hybrid strategies are much more flexible when market preferences shift and are therefore less exposed to strategic uncertainty. All in all Raynor’s (2007) work is a valuable extension to the strategic management literature that leads to an assessment of strategic choice on at least two dimensions: profitability and risk. A thorough discussion about this topic forms the foundation of the study:

Porter’s generic strategies do not solely explain strategic choice of firms, since the reduction of corporate risk is a viable motivation for firms to choose a hybrid strategy.

The contribution of the study is then twofold. First Porter’s typology is tested with German data. Secondly Raynor’s argument is tested, whether the very same firms that are more successful have a higher risk of running into corporate bankruptcy.

In order to have the necessary information, the first section of the paper reviews the literature. Here the generic strategies are explained and the most important studies on the topic are summarized in a table. Then the “Strategy Paradox” is presented that describes Raynor’s (2007) argumentation for an increase in risk with pure strategies. Two conflicting theories are mentioned that deal with the question whether risk and return is positively or negatively related. In between this first part, two hypotheses are given that are tested with data from the Centre of European Economic Research in Mannheim (ZEW). Section 3 presents the dataset, the variables and the methodology. The results are analyzed in section 4 and the differences in performance and risk are compared among the strategic groups. In section 5 the most important results are discussed and potential explanations are given that lead to suggestions for further research. Additionally implications for managers are proposed and the limitations of the study are mentioned. The paper ends with a conclusion and a personal view on the discussion.

2. Theory and Hypotheses

2.1 Porter’s (1980) Generic Strategies and Performance

Porter’s (1980) bookCompetitive Strategyhas received a great deal of attention in the strategic management literature (Miller and Friesen, 1986). Here Porter claims that competitive strategy is the search for a favorable competitive position in the industry, which can erode or improve, depending on a firm’s choice of strategy (Porter, 1980). He derived a conceptual typology of three generic strategies that has already become a classic among scholars (Miller and Friesen, 1986). They are cost leadership, differentiation and focus strategies and will be presented to the reader in detail in the next section. The literature outlines three reasons why Porter’s typology of generic strategies is especially useful (Hambrick, 1983).

Firstof all it builds on previous findings and bears some relationship to other strategic categorizations, typologies and taxonomies in the literature (Miller and Friesen, 1986; Hambrick, 1983). For example Hall (1980) revealed in an in-depth study, that success comes from either the lowest cost position, or the highest product/service/quality position in hostile environments, which is related to Porter’s (1980) cost leadership and differentiation strategy. Miles and Snow’s (1978) strategic typology distinguishes between prospectors that “find and exploit new product and market opportunities” (Miles and Snow, 1978, p.551) and defenders that “produce a limited set of products directed at a narrow segment of the total potential market” (Miles and Snow, 1978, p.550). Prospectors differentiate via product innovation and defenders focus on competitive pricing (Miles and Snow, 1978). Moreover Henderson (1979) discussed the importance of cost leadership. Cost leaders pay great attention to employee productivity, asset use, and discretionary expenses, which often results in the lowest prices in the market (Henderson, 1979).

Second, Porter’s typology is “appropriately broad, but not vague” (Hambrick, 1983, p.688), which means that Porter did not limit his classification to special circumstances, such as declining industries (Harrigan, 1980), turnaround situations (Hofer, 1980), or manufacturing businesses (Galbaith and Schendel, 1983). It applies to a wide range of business situations (Chrisman and Hofer, 1988) and even though it is a simple model it captures a great deal of complexity (Miller and Dess, 1993). These factors make Porter’s typology especially useful for the investigation at hand, since the dataset is large and not limited to industry factors.

Third, past empirical research findings have shown that there is a general consistency between commitment to one of Porter’s strategies and higher performance (Dess and Davis, 1984; Hambrick, 1983; Galbraith and Schendel, 1983). Section 2.1.4 describes this relationship in detail and analyzes how a firm can achieve a sustainable competitive advantage, which is the basis for above-average performance in the long run (Porter, 1980).

It is believed that due to the reasons above, Porter’s framework of generic strategies provides a valuable research tool, in order to examine the relationship between performance and strategic choice in the German economy.

Porter’s ultimate goal ofCompetitive Strategyis to distinguish between successful and unsuccessful companies on behalf of their strategic choice: cost leadership, differentiation, and focus (figure 1). A firm must make a choice between one of the three generic strategies or else it will be “stuck in the middle” and suffer from below-average performance (Porter, 1980, p.40). The next section will acquaint the reader to each of the three strategies.

Figure 1: Porter’s Typology and Generic Strategies^[2]

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2.1.1 Cost Leadership

Firms that have a cost leadership strategy strive to become the low-cost producer in the industry. The sources of cost advantage vary and depend on the structure of the firm’s industry. It can range from the pursuit of economies of scale in manufacturing industries to the lowest overhead costs in human resource intensive industries, e.g. security guard services. Usually a low cost producer sells a standardized product on a broad range and tries to exploit all sources of cost advantages (Porter, 1980). Therefore a cost leadership strategy is most viable for large firms, since they have greater access to resources and lower overhead costs, which results in lower per-unit costs (Wright, 1987). Once a firm has established itself as the cost leader in the industry, not only an above average performance is likely, but it can also command prices to the industry average. Prices at or below its rivals are beneficial to the cost leader, because it translates into above industry returns (Porter, 1980) and provides barriers to enter the market (Miller and Friesen, 1983). The cost leader may even provide a “margin of safety” (Miller and Friesen, 1983, p.38) in case suppliers increase prices or there is bargaining from customers (Miller and Friesen, 1983). However the cost leader cannot ignore the competition from firms with a differentiation strategy, because if the product is not acceptable by buyers, the cost leader sells at discount which nullifies the cost advantage. Porter (1980) also emphasizes the importance of the strategic logic of cost leadership, i.e. only one firm can aspire to become the cost leader within the industry. As soon as more than one firm strives to become the cost leader, rivalry becomes so fierce that the consequences for profitability in the industry are disastrous (Porter, 1980).

2.1.2 Differentiation

A differentiator is unique within its industry along dimensions that buyers value in a way, that they are willing to pay a price premium. These dimensions can be for example, a superior product quality, the product itself, the delivery system or the marketing approach (Porter, 1980). The aim is to provide the buyer with superior value that creates brand loyalty. Once brand loyalty is established, the firm benefits from price inelasticity on the parts of the buyers, competitive barriers to entry and higher sales margins (Miller and Friesen, 1986). Above-average performance can be accomplished if the price premium exceeds the extra costs of being unique.

As much as the cost-leader cannot ignore the differentiator, the differentiator cannot ignore its cost position. If costs are too high the premium prices are nullified (Porter, 1980). Nevertheless the differentiation strategy implies costly activities, such as extensive research, product design and marketing efforts (Miller and Friesen, 1986), which prevents differentiators from becoming the low cost producer (Porter, 1980). Depending on the dimensions that buyers value, there can be more than one differentiator within an industry (Porter, 1980).

2.1.3 Focus

Focus, the third generic strategy, is based on adopting a narrow competitive scope, which makes this strategy different from the others, who have a rather broad scope (Porter, 1980). This niche can be either “a certain kind of customers, a limited geographic market, or a narrow range of products” (Miller and Friesen, 1986, p.38). The focuser can achieve a competitive advantage within a niche, because large firms are either not attracted to the niche, or have overlooked the potential (Allen, 2007). The narrow focus in itself though is not sufficient for a competitive advantage. The firm needs to optimize the strategy on two variants: cost focus and differentiation focus.

With cost focus a firm exploits differences in cost behavior of the target segment and with differentiation focus a firm takes advantage of special needs of buyers that are not served from firms competing more broadly (Porter, 1980). Above average performance is possible if the focuser serves this niche exclusively (Porter, 1980) and the market is heterogeneous, where consumers demand more variety and options (Miller and Dess, 1993; David, 2002). Wright (1987) found out that focus is the only viable strategy for small firms, because they lack access to resources. Therefore one risk of a focus strategy is, that broadly targeted competitors overwhelm the segment once it becomes economically attractive (Porter, 1980).

2.1.4 Competitive Advantage or Stuck in the Middle

Porter describes firms that are torn between cost leadership, differentiation, and focus as being “stuck in the middle” (Porter, 1980, p.41). He claims that firms that donothave a strategic commitment towards one of the three generic strategies (hybrid strategies) have an inferior positioning in the market to compete; they did not find the “recipe for above-average performance” (Porter, 1980, p.41).

A firm that is stuck in the middle can only be successful if either the industry structure is favorable, or if their competitors are also stuck in the middle, which is unlikely. Consequently a stuck in the middle position derives from the firms unwillingness or inability to make choices about a clear strategic path (Porter, 1980). These firms strive for “competitive advantage through every means, but achieve none” (Porter, 1980, p.41). On the other hand, Porter has summarized the results of several investigations in a graph (figure 2) that describes the relationship between cumulative volume of production/market share and return on investment (Wright, 1987).

Figure 2: The Relationship between Cumulative Volume of Production/Market Share and Return on Investment^[3]

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Here Porter claims, that firms who have implemented one of his generic strategies benefit from higher returns on investment, than firms with hybrid strategies. The graph is U-shaped, due to two reasons.

First, it is believed that firms competing with the cost leadership strategy will have higher returns on investment with larger market shares. Second, firms competing with either differentiation or focus observe higher returns on investment with smaller market shares (Wright, 1987). With regard to these results we adhere that firms with Porter’s generic strategies are more successful than firms with hybrid strategies.

Hypotheses 1:

The commitment towards Porter’s generic strategies (cost leadership, product differentiation or focus) enables German firms to outperform those competitors that do not have a commitment towards one of Porter’s strategies.

2.1.5 Generic Strategies and Performance: Major Studies

Table 1 briefly summarizes the results of the major empirical investigations. Besides Miller and Friesen (1986) and Wright (1990) all results are consistent with Porter’s assumptions. Porter’s typologies characterize the high success strategies in the capital goods industry, paint industry, electronics industry, manufacturing industry and even for e-businesses. Firms that have pure strategies perform better than firms that are not committed to one strategy, as far as ROI and sales growth is concerned. Besides O’Farrell (1992) the literature excludes European data, which can be interesting for the investigation at hand, looking at German firms and their strategic orientation. One contribution of this study is therefore to look whether Porter’s typologies hold true in the German economy.

The major source of data stems mostly from small to medium sized enterprises in the US or Canada, leaving out major companies with more than one thousand employees. The dataset at hand includes small firms as well as large firms and can therefore give a clearer picture on the validity of Porter’s theory as far as firm size is concerned. It is also assumed that a firm’s strategic orientation is more accurate in the investigation at hand, as the firmitselfdetermines which strategy it pursues and not the author of a study, by analyzing factors that fit the characteristics of a certain strategy (e.g. Hambrick, 1983).

More recent studies suggest that Porter’s theory is still applicable to a number of industries. Not only that Kim et al. (2004) found out that Porter’s theory explains performance differences in Korean e-businesses, but also Torgovicky’s (2005) results reach the same conclusion. He investigated two Israeli sick funds and found out, that the superior performance sick fund is characterized by extensive use of differentiation and focus strategies, whereas the one that is inferior is stuck in the middle. In this case Porter’s theory is applicable to not-for-profit institutes in the health care system. Just recently Shah (2007) examined the relationship between strategic group membership and performance in the retail sector. Contrarily to what was expected the results show that the most profitable strategic groups are the ones that “use variations of Porter’s three generic strategies” (Shah, 2007, p.1). Therefore it remains to be stated that even though Porter’s typologies are not novel, they still have academic significance in the strategic management literature. It is assumed that they have enough explanatory power to describe performance differences in the German economy. Another motivation for this study is based on the limitations of previous studies. The generalizability of these studies is questioned due to the fact that the “relative importance of the competitive methods may vary across, as well as within industry environments” (Dess and Davis, 1984, p.485). This study circumvents the potential effect of industry characteristics by grouping firms around their strategic orientation no matter what industry they operate in. Section 3 describes the dataset and the variables in more detail.

Exploratory studies suggest the same results as empirical ones. For example Allen (2007) investigated the use of Porter’s (1980) generic strategies in Japan and found out that the lack of strategic focus is the major reason for the downfall of several Japanese firms. Firms such as Honda, Sony, and Nintendo though “rise to global dominance by their well developed and defined corporate strategies” (Allen, 2007, p.72), and can therefore be seen as the true Japanese success stories. Other firms, such as Mitsubishi, slowly detach the strings of Japanese management culture, which constrain the global competitiveness and “have discovered Michael Porter’s (1980) generic strategies as a possible impetus for corporate change and renewal” (Allen, 2007, p.71). Finally the author’s conclusion is a transition to Porter-based strategies in the Japanese economy (Allen, 2007). Considering these well documented findings, it is assumed that there is also a significant relationship between Porter’s generic strategies and firm performance in the German economy.

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^[1]http://www.manager-magazin.de/unternehmen/artikel/0,2828,384834,00.html

^[2]Figure 1. Porter’s Typology and Generic Strategies. From Competitive Advantage: Creating and Sustaining Superior Performance, by Michael E. Porter, 1985, Free Press: New York.

^[3]Figure 2. The Relationship between Cumulative Volume of Production/Market Share and Return on Investment. Modified Version from: A Refinement of Porter’s Strategies (p.100), by Wright, P., 1987,Strategic Management Journal.