Michael Porter’s Competitive Advantage Theory: Focus Strategy for SMEs

This report was commissioned to examine whether small and medium enterprises (SMEs) that target only a few market segments will promote their products and services more effectively than SMEs that target the mass market. The research draws attention to Porter’s generic theory of competitive advantage by mainly concentrating on the third of his competitive advantage strategies, the focus strategy. Theory as well as a practical survey was used in order to falsify or approve the research question. Theory revealed Porter’s focus strategy to have several key advantages over a mass market strategy which make firms pursuing such a strategy more effective in their product promotion efforts. First, a focused firm does not have to devote substantial resources into being all things to all people entailing less expenditure of time and money in comparison to a mass market strategy. Second, empirical evidence was found that customers do value specialized firms due to their focused capabilities. Third, a focused firm is less likely to be overwhelmed by great amount of different customer request and is more likely to identify and adapt to market changes in a quick time manner. Besides the advantages of a focus strategy, the research question is only supported when the SME makes bigger rivals to accommodate their existence in the segment(s) by creating circumstances in which the cost for the bigger rival in fighting the SME exceeds the cost of accommodating the SME. 27 SMEs from South Germany have returned completed questionnaires which were used to find practical evidence for answering the research question. The used research methodology in the inductive practical approach was quantitative based on numbers which were evaluated by using Excel. Results revealed several tendencies which partly support theory. First, SMEs that pursue a focus strategy are more likely to do this with a differentiation focus and secondly and most importantly they tend to have fewer problems in attracting and retaining customers. There was no indication that focused SMEs are more likely to see and adapt to market changes on an early stage and there was also no tendency visible whether SMEs with a focus strategy are less likely to be overwhelmed with customer requests. In conclusion, theory supports the research question only when the firm is able to adequately implement the focus strategy. Furthermore, also some evidence from the practical part support the research question. However, the little sample size from only one specific region does not allow results to be generalized. The partly inadequate ordering of the survey question in the questionnaire as well as the use of appropriate evaluation software further limited results validity.

1. Introduction

The following research paper will analyze whether Small- to medium enterprises (SMEs) that target niche markets will promote their products and services more effectively than SMEsaiming at the mass market. The paper will first take a look at the theoretical part by stating some background information including elements of Michael Porter’s focus strategy and elements from other authors that support Porter’s view. The second theoretical section will take a look at some criticism Porter’s theory received over the last decades arguing that a focus strategy on its own does not guarantee that SMEs are able to promote their products more effectively. The practical part will investigate the results of a SME survey conducted with 30 SMEs from Southern Germany after the research methodology has been stated in more detail.

2. Theoretical Background and Hypothesis

Focus strategy is a generic strategic thrust defined by Porter in 1980 that emphasizes segmenting an entire market and focusing on only one or a few segments. Market segmentation refers to the process of dividing a market into a distinct group of buyers that require different products, services or marketing mixes (Williams, 1990). Segmentation can either be in the form of demography such as age or occupation, it can be of geography such as states, regions or countries, it can be of behavior bases such as product knowledge, usage, or attitudes or it can be of psychographic bases such as lifestyle, values or personality. On the one hand businesses have the possibility to either concentrate on one or more of such segments which is referred to as a focus strategy or they concentrate their efforts on serving all such segments within the industry which is referred to as a mass market strategy. Porter argues with his focus strategy that firms that concentrate on a small niche are enabled the firm to better service that smaller group rather than a big one. According to Porter, companies that follow a focus strategy should provide either a differentiated product or service to the segment or a low cost product or service for the chosen segment. A combination of both was not possible in Porter’s view and he refers to firm’s who have such a combination as being “stuck in the middle”. With stuck in the middle, Porter meant firm’s who are unwilling or unable to make strategic choices and its attempts to compete by every means preventing them from achieving competitive advantage leading to above-average performance. Thus competitive advantage was in Porter’s view only possible with a clear focus on segments accompanied with either a clear cost or clear differentiation strategy, while last one he believed to be more easily achievable. Michael Porter’s focus strategy was developed in a time where firms were confronted with increasing competition. The main goal of firms back in that time was therefore placed on saving the firm’s existence rather than on profitability. Over the last decades, Porter’s views have been challenged form several sides along with one of the arguments that Porter saw the focus strategy rather a general strategy for all companies rather than distinguishing them between their size. This report focuses on SMEs and the hypothesis of this report therefore challenges Porter’s view to find out whether a focus strategy is the best strategy for SMEs to gain competitive advantage. The Hypothesis is formulated as:

Hypothesis: Small- to medium enterprises (SMEs) that target mass markets will promote their products and services more effectively than SMEsaiming at one or a few market segments.

Obviously, a SME that concentrates on the mass market has much greater sales potential since a whole industry provides just far greater demand for a SME’s product or service than does a single market niche. However, firms concentrating on mass markets must devote substantial resources into being all things to all people making a mass market strategy entail greater cost and time than does a focus strategy. Same refers to launching a product which is much more costly when launching it in the mass market rather than in the niche market. This is due to promotional and distributional costs which both rise simultaneously with an increase in the market size in which the product or service is launched in. Friedrich (2007) argues that, customers do value specialized firms as they see such firms as the best possible solver of their problems. She says that customers believe that the specialized firms must have the most insights into what their problem is. She gives a couple of examples: If a person suffers from a heart disease he would rather go to a hospital that is specialized in heart diseases than to a general hospital. Same refers to the sale of a company which would preferably be undertaken with a specialist for acquisition & mergers rather than with the next solicitor around the corner. Because of this concentration of knowledge on a focused area, the firm must only have information about his segments rather than the entire industry which makes the firm less likely to dissipate his efforts and the firm will be quick in identifying and adapting to upcoming market changes.

a) Focus Strategy and Competitive Advantage

Porter argues a focus strategy to work out only if a company is able to differentiate itself significantly towards its competitors either by cost or differentiation. Such a protruding feature would partly isolate a firm from competition as the feature would be hard and costly to imitate. However, Porter argues that a feature must not only be protected from imitation but also be needed by the market. The products and services that meet the greatest need in the market and are protected against imitation are the most profitable once. Porter sees competitive advantage in the five from him developed industrial forces. First, due to the high cost of imitation, the firm would be protected against new entrances and thus entry barriers were greater. Second, core competencies that meet the need of the market are highly wanted in the market and the lack of alternatives due to the imitation barrier lowers buyer power. Third, specialized products and core competencies do also protect against the thread of substitutes. Fourth, it is too costly for rivals to imitate the specialized firm’s strategy with which it serves its customer needs making rivals less likely. Fifth, low volumes which are more likely to occur for focused firms stand for high supplier power. Supplier power is thus identified as only negative issue among all the five forces. However, the occurrence of an increase in supplier power depends on what focus strategy a firm is pursuing. A product focused strategy lowers supplier power since input material for a few products are bought only rather than from many products always a bit. This would create bulk orders reducing supplier power. Also under a differentiation focused strategy, costs can be passed on to buyers as they are willing to pay for the specialized service or product.

b) Porter’s Focus Strategy and Criticism

However, Porter’s focus strategy is rather paying attention what a firm should do and less on how the other, bigger firm’s reactions are to what the firm does. This implies that a focus strategy does not necessarily cause products and services to be promoted more effectively in firms pursuing a focus strategy. This section will take a look at the criticism towards Porter’s focus strategy of competitive advantage, arguing that a focus strategy on its own does not protect a SME against defaulting and it will indicate how a SME can avoid such obstacles. All the segments an industry is dividable in, are either served by a big rival or are ignored by them. Is the niche occupied by a bigger rival will it either choose to accommodate the SMEs entry or it will aggressively try to deter the SMEs entry. In the latter case, is a market segment initially ignored by the bigger firm, it will attempt to capture the market niche from the SME by supplying a product similar to that offered by the SMEs. On the other hand, if the segment is already being supplied by the bigger firm, then it will attempt to defend its market aggressively against the entry of the SME. The following sector will take a look on the risks coming from a big rival can bring about when a SME pursues a focus strategy in one or a few segments and what opportunities an SME has to abandon such risks, and whether threads coming from big rivals are less risky when a firm focuses on one or a few segments in comparison to the mass industry.

c) Focus Strategy for SMEs and Competition (Critics Porter)

The lack of resources is very often cited as one of the major obstacles faced by Small- and medium enterprises (SMEs) in comparison to their counterparts the very big enterprises like Multinational Corporations (MNCs). Of the three generic strategies proposed by Porter (1980), only the focus differentiation strategy seemed to be the adequate strategy for SMEs to pursue giving their limited resources. A resource limitation would deter the SME from competing solely on price as the bigger rival has the advantage of economies of scale making him more easily to afford to lower its prices. In case the MNC is trying to outrange an SME off the market or prevent an SME entrance into the market it would be able to do so with its greater availability of resources. However, even though the MNC might have the resources to fight SMEs who are in or trying to enter the market, the MNC still faces barriers that force them to accommodate an SME’s existence or entrance in the market niche. This is the case when the cost of aggressive retaliatory action against the SME may far exceed the cost of accommodating the SMEs’ presence in the market (Lee et. al 2002).

i. The Substitution Strategy

SMEs that choose to enter a niche market may be able to be accommodated when their products are substitutable but yet differentiated from the products of the bigger rival. The bigger rival would be confronted with either offering a similar counter-product in the SMEs market niche or initiate a price war with their current substitutable product. The bigger rival has to weigh up whether accommodating the SME weighs out the cost of fighting it. Due to greater resources, the bigger rival is most likely to succeed in this price fights but has the cost of lowered profitability during such a fight. The bigger rival has to abandon profitability due to development costs or with its price fights and might even after a successful fight not be able to raise prices to a profitable level again due to negative market signaling effects. Also, lowering prices in one market niche might force the bigger rival to lower its prices in other niches as well. Thus, a SME is having a competitive advantage when it offers a substitution product in a niche market that outweighs the benefits for a bigger rival to compete with it.

ii. The Free-Riding Strategy

As a bigger rival would abandon profits if it lowered its prices, it might also accommodate an SME even though the SME provides the exact same product in the market niche as the bigger rival only to a lower price. The bigger rival would lose market share but fighting the SME on a price basis would even be less profitable for them. This is the case when SMEs are able to offer lower prices by having little product development and promotion costs as they free-ride on the market developments already established by the bigger rival. An example would be Red Bull who used to be one of the only energy drink providers before several SMEs launched cheaper ones and joined the hype in an increasing and already established market. Red Bull’s option to fight the SMEs would have by far outreached the benefits of such an action.

iii. Deterrence Strategy

Although the substitution and free-riding strategies aim to force an incumbent competitor to accommodate an SME's entry, the incumbent might nevertheless decide to fight the SME's entry, if it believes that such a move would help it establish a reputation for toughness and effectively deter future entries by other potential entrants. In such circumstances SMEs could deter such aggressive actions by a credible commitment to stay in the targeted market. Such commitment signals would include such things as forming strategic alliances making it harder for the bigger rival to put his aggressive strategy through.

iv. Niche Strategy

Apart from the three strategies just mentioned, SMEs are only left with the option of pursuing a focus strategy and enter a niche that is neglected by the bigger rivals. In some industries, there are niches that bigger rivals rather ignore providing chances for SMEs. One reason why the bigger firm might ignore a market niche is because it is locked into inefficient practices and hence, could not adapt to the demands of the market niche (Cooper et al., 1986). Ghemawat (1991) argues further, that the bigger firms avoid supplying some market niches for fear of sales cannibalization on the other market segments that are already supplied by them. An example would be a printing-office in South Germany who was among the survey correspondence for the focus strategy research project for the practical part of this paper discussed after this theoretical part. This label printing office was concentrated on the customer segment of direct-marketing who use labels for some of their promotional activities. This segment is known for sudden promotional activity launches and labels are often needed in a very short time frame. Big printing companies are with their bureaucratic size and structure not able to provide products in such a short time-frame giving the SME with its “speed-boat” size a competitive advantage.

Kao (1981), explicitly recognizing the resource disadvantage faced by SMEs against bigger firms, argues that “if there is no niche, there is no hope for the firm’s survival and prosperity”. The three other strategies besides the niche strategy mentioned above have indicated ways and circumstances under which SMEs are able to profitably survive without the existence of a niche market that is ignored by bigger rivals. However, what strategy to pursue for an SME depends on the anticipated reactions of the bigger competitor and the SME’s targeted segment combined with its core capabilities. Before a SME chooses a market segment that is ignored by a bigger rival, thus intending to pursue a niche strategy, it must have developed a sustainable competitive advantage just like the label printing office and that will deter the bigger rival to compete against the SME. As such sustainable competitive advantages take time to establish. Many SMEs pursue a focus strategy by which a segment is concentrated on but has a bigger rival as competitor within. Is the bigger rival anticipated to rather be aggressive than accommodating, then SMEs should adopt a deterrence strategy and preempt the anticipated aggression by credibly signaling its commitment to stay in the targeted markets. If the incumbents are expected to be accommodating of the entry, then the substitution or free-riding strategies may be adopted. The appropriate application of the free-riding, the deterrence, or the substitution strategy would force the bigger rival to accommodate the SME in the segment rather than fighting it. Thus SMEs can penetrate the market for their own sake without having a competitive advantage and without having the same amount of resources as the big rivals within the segment. Thus, this section has brought to light that a focus strategy on its own is no guarantee for greater effectiveness in product and service promotion. But, still this section has also indicated what SMEs can do to have the guarantee of greater effectiveness in product and service promotion.

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