Michael Porter, author of Competitive Advantage and father of the 5 Forces industry analysis, has said that there are three fundamental strategies for a firm in any industry: Cost Leadership Strategy, Differentiation or Branding Strategy, and Focus or Niche Market Strategy.
In a cost leadership strategy, companies sell their out put at low prices and reduce costs to maintain margins. High volume, low cost production is their route to profits.
In a branding strategy, companies focus on providing value to the mass market. Mass marketed, high priced goods and services associated with strong value offerings are their route to profits.
In a niche strategy, companies serve specific market segments with a value offering that meets their needs better than others while ignoring the demands of the mass market. Profits are supported by high margins in their low volume, highly targeted, market segments.
The Absence of Cost Leadership
While the three fundamental strategies are usually present in various industries, one is mostly absent in the business software application industry: Cost Leadership. Why?
Take financial software for example. Quicken and Peachtree have both pursued the branding strategy targeting small and medium sized businesses. SAP, PeopleSoft, Lawson, and others meanwhile pursued the branding strategy targeting large corporations. And Argus, SDS, ACI and a plethora of other competitors have pursued the niche strategy targeting specific industry verticals. Yet we don’t hear of a discount firm for business financial software. When a product firm does highlight its price, it is usually targeting a specific market niche with a specific, right-sized solution and not the mass market with a general solution.
Michael Porter himself stated that cost leadership is a tenuous strategy to undertake. According to Porter, firms executing a cost leadership strategy are at risk of having a branded competitor lower their prices. When the branded competitor lowers its price, the price differential between the branded and the cost leader products’ is squeezed but the customer’s benefit differential is not. Consequently customers rationally switch to the branded competitor’s product to capture a larger portion of the value.
But, is squeezing the value differential sufficient to abdicate cost leader strategies in business software? While value differential squeezing is a compelling argument, there are other causes. I have identified three in my research.
First, businesses purchase application software out of their demand for improved productivity. As such, the value of a business application is measured according to its ability to meet the business’s challenge and fit within their infrastructure. Price competition is secondary to value competition in business application software.
Second, software products have little marginal costs and much upfront development costs. Firms producing software are in a highly leveraged business. The upfront investment in developing the product must be recouped in subsequent sales. Once the product is produced, all further costs are associated with future product development or current sales and marketing issues. The actual reproduction and distribution costs are already near zero. Cost leadership relies upon reducing costs in production and distribution. When these costs are near zero, it is difficult to lower them further.
And third, price competition strategies are usually associated with easy market access. Low price leaders skimp on marketing efforts and rely on distribution networks to get their product to market. Currently, market access through a distribution network has insufficiently developed for most business applications. As such, small firms producing a new software product must create their distribution network.
In my research, I have found only one firm that attempted to undertake a cost leadership position. It lowered its price to one-fifth of the leading competitor’s for an otherwise equally strong product. It also reduced the sales and marketing effort in anticipation of winning deals based upon their lower price and relative value proposition. Unfortunately, the lower price was an insufficient impetus for customers to investigate and purchase the firm’s offering. The result was a continued decline in revenues.
Matching the Industry Structure
In other industries, a cost leader position is a questionable position at best. In business application software, cost leadership is simply untenable. Branding and niche strategies that focus on providing value will continue to outperform in business application markets until the market demands and cost structures change.