The Four Strategies
How to understand the essence of any business
There’s really only four competitive strategies:
- Broad + differentiated
- Broad + low cost
- Niche + differentiated
- Niche + low cost
Of course, this might strike you as a wild oversimplification. But I want to convince you that it’s not.
In fact, I believe this lens is one of the most powerful tools that any founder, operator, or investor can have. Because it cuts to the core of the two most important challenges every business has to overcome in order to succeed: why would anyone buy your product, and how can you make money selling it?
Understand that, and everything else a business needs to do clicks into place. Overlook them, you’re in grave danger of losing your way.
It’s important to know that this “four strategies” framework wasn’t just something I made up. It was created by the most cited author in the fields of business and economics, Michael Porter. He introduced it in his book, Competitive Advantage, and it’s been a staple in business schools and in practice ever since.
Navigating the market without this framework is like trying to navigate the world with no concept of north, south, east, and west. It’s possible — our ancestors certainly did it! — but those equipped with a compass can go much further and faster without getting lost.
This essay is split into five major sections. The first four sections cover each of the four strategies. These all contain one main example, three shorter examples, and some additional commentary on how to make the strategy in question work. The final section covers a special case: strategy for monopolies.
Companies examined include:
- Dollar General
- Blue Nile
- Southwest Airlines
- Blue Bottle
- Eight Sleep
- Smile Direct Club
- Bird, Lime, etc
- Planet Fitness
- The Financial Times
Let’s get started :)
Broad + Low Cost
All strategies require obsessive focus. But “focus” doesn’t always mean a narrower segment of customers. Sometimes it can take the form of obsessing over delivering acceptable value to a wide range of customers at a lower price than anyone else.
Here, the goal isn’t to charge the lowest price possible, but instead to have the lowest cost possible without sacrificing too much in product performance. Then, you’re in position to charge a bit less than anyone else and still maximize profits.
Dollar General. Despite all the talk about the death of retail, Dollar General is thriving. Over the past five years the Dollar General stock (NYSE: $DG) has earned a 129% return and shows no signs of stopping. This is all a result of their focused execution of the “cost leadership” strategy.
It starts with how they choose retail store locations. Dollar General stores are built in places that Walmart (their biggest competitor) often won’t go—inner city neighborhoods and tiny rural towns. Since these neighborhoods aren’t attractive to most retailers, Dollar General pays rock-bottom prices for rent, yet still remain in close proximity to their target customer.
Once they find a location, Dollar General stores are cheap to develop. They cost only $250k to open and each store is around 7,300 square feet - about one-tenth the average size of a Walmart.
Dollar General also doesn’t employ any excess staff members (such as greeters) which further keeps costs down.
Finally, Dollar General offers a no frills shopping experience with a limited product selection. Their stores have only 10-12 thousand unique items (compared to ~60,000 at a Walmart Supercenter) and they rarely carry any fresh produce. This helps to simplify inventory buying in addition to saving money on cold storage and product spoilage.
These four factors—lower rent, cheaper build-out, fewer employees, and a limited product selection—all contribute towards what Porter would call low direct operating costs. It’s one of the main ways to pursue the cost leadership strategy.
- Blue Nile. Unlike Tiffany’s or Zales, Blue Nile has no retail locations. Therefore, they have no retail staff, leases, or other associated costs. They don’t even have a warehouse where they store all their diamonds. Intead, they use a drop-shipping model. This is how they’re able to offer engagement rings and other diamonds at a lower price. Their drop-ship model not only allows Blue Nile to have a higher cash balance than retail stores (since it’s not tied up in inventory), but also allows them to offer a wider selection. Additionally, they trade the commitment of multi-year contracts with suppliers for favorable payables terms - often 30-120 days, freeing up more cash.
- Southwest Airlines. While airlines today have copied many of Southwest’s best practices, a big reason they gained market share in the 80s and 90s was due to innovative cost cutting strategies. For example, they were one of the first to offer short-haul, intra-state flights instead of the hub-and-spoke model that most airlines adopted. Additionally, they provided cheaper food ($0.20 per meal vs $5.00 per meal industry average), didn’t use travel agents, and flew into uncongested airports of small cities. This last part - flying into small airports where the runway wait times are shorter - is what Porter calls achieving high asset utilization. Airlines can’t change their biggest fixed costs (owning the planes), but they can get more flights out of them.
- Costco. Costco is a discount retailer using a cost leadership strategy - similar to Dollar General - but executes it in a different way. Costco buys in bulk to get discounts on supply and only charges a small markup in their stores. In fact, after accounting for store costs (rent, employees, etc.) they usually break even. How does Costco make money then? If you want to shop at Costco, you have to buy their $60 / year membership. Since the membership doesn’t have any incremental costs, it goes straight to the bottom line. This model allows Costco to undercut competitors - thus attracting a price-conscious customers - while still turning a profit through the memberships.
Summary: The key thing to remember here is that a cost leadership strategy starts with a unique advantage in unlocking lower operating costs. Don’t make it fancy, make it cheap.
Broad + Differentiated
Sometimes new technologies come along that are just better. The iPhone, for example, wasn’t created to serve any particular niche or segment (e.g. business users, teenagers, etc). Instead, it’s for anyone willing to pay for quality.
Here, the key is to understand what your customers care about, and give it to them in a superior way. In order to do this, you’ll often (but not always) have to spend a bit more money. But that’s ok, so long as your customers are willing to pay a premium.
Companies that manage to do this are said to have achieved “differentiation.”
Slack. One interesting thing about software is how common it is for SaaS companies to follow a “differentiation” strategy. It’s hard to compete on price in this sector, because everyone has basically zero marginal distribution costs, and the main expense is your team (which you really don’t want to skimp on). There’s not a lot of interesting cost savings to be had in the same way there would be if you were manufacturing widgets.
So, instead, most companies try to offer superior value and charge a higher price.
Slack is a perfect example of this. They’re able to charge a premium by starting with several innovative features (seamless messaging, public/private channels, and secure backup, for example) and leveraging that into creating two kinds of network effects:
The first is their ecosystem of integrations. Because Slack is the most popular team chat app, everyone building complementary products has an incentive to integrate with them first. This increases the value to Slack’s users without costing Slack a dime.
The second is their user-to-user network effect. If I used Slack at my old company, and I have multiple secondary slacks I’m a part of, then I’m going to prefer to just keep using Slack for my team chat. To strengthen this even more, they introduced “shared channels” where employees from two different businesses can communicate with each other.
Ultimately, “differentiation” strategies work when a customer has an option to purchase a cheaper option but still buys the more expensive one. There are other messaging systems available, including some that are cheaper or focused on specific verticals, but many companies continue to prefer Slack.
- Pfizer (Lipitor). One of the most durable methods to differentiate is through intellectual property or patents. Since 2000, the pharma giant Pfizer has owned the patent for Lipitor, a drug that treats high cholesterol. Lipitor generated over $131 billion in revenue for Pfizer in just eleven years and is considered the most valuable drug ever developed. Because of the patent, no one could undercut Lipitor, and it successfully charged customers a premium up until the patent expired and competitors entered the market. (This is just one of a broader class of “government protection” moats, that, whatever your opinion on their efficacy for society, tend to be good for the business’s profits!)
- Blue Bottle is differentiated in two ways: they prepare the best-tasting coffee and they have a terrific in-store environment. Making better coffee requires higher quality beans and takes longer to prepare - which also costs them more - but it pays off with the taste. So their customers are willing to pay a premium. Not only is the taste of the coffee exquisit, the environment is too. Blue Bottle relies on the friendliness and expertise of their baristas to provide a welcoming environment that encourages customers to enjoy their coffee products in-store.
- Eight Sleep. Mattresses normally compete on feel or price, but Eight Sleep’s “pod” mattress offers on a new form of value: temperature control. Their marketing targets athletes, for whom sleep is especially important, but it’s an innovation that anyone could benefit from. Their technology is protected through patents, but it will be interesting to see if other mattress companies can catch up. They’re still a new company, so only time will tell if their strategy will work, but they’re worth mentioning as an example of a new company pursuing a “broad + differentiated” strategy.
Summary: The differentiation strategy is achieved when a company meets the aspirational needs of customers as shown through a willingness to pay a premium for that product or service.
Niche + Low Cost
This strategy is somewhat rare, but it’s a fascinating one.
Usually when a business focuses on a niche, they charge more for their product and provide extra functionality that’s only important to customers in that niche. But sometimes a business notices a segment that’s actually overserved, and invents a way to serve that segment more cheaply.
Smile Direct Club. Billions of people worldwide — 60% to 75% of the population* — suffer from malocclusion (the misalignment of teeth). Traditionally, metal braces are used to treat this condition, and more recently Align Technologies’ Invisalign product has served the market. But because of cost, only about 1% of people with malocclusion get treatment in any given year.
Enter Smile Direct Club. When the Invisalign patents expired in 2017, they jumped at the opportunity to provide a cheaper option to a specific segment of the market.
Smile Direct Club is able to keep costs low because they only accept patients that require mild tooth crowding and tooth spacing. These cases can be treated with minimal doctor intervention, but still represent a sizable market that wouldn’t have otherwise had access to any treatment.
The average cost of treatment with braces is $5k - $6k and the average cost of treatment with Invisalign is $3k - $5k, while Smile Direct Club is just $1,895. Because the treatments are simpler, patients can order online and treat themselves. They also don’t have to keep many dentists on payroll. Treatment with SDC takes up to 50% less time than traditional methods, further reducing the costs.
In this case, Smile Direct Club is able to offer a lower production cost by targeting patients with mild malocclusion. The interesting piece, of course, is that it’s only possible because they only target a subset of the market.
- Electric Scooters. It’s too soon to say whether this will be a good business. But the theory behind companies like Bird and Lime was compelling enough to attract hundreds of millions in venture capital, and millions of customers: electric scooter rides can be an extremely compelling alternative to walking, driving, or hailing a cab. Here, the broader market is defined as “urban mobility,” and niche targeted is “trips between 1 and 3 miles.” By offering a different, much cheaper way to get around, these companies are pursuing a “niche + low cost” strategy.
- Planet Fitness. Planet Fitness became one of the largest gyms in the US by targeting a specific demographic: the 80% of the population that doesn’t already have a gym membership. Their marketing slogan makes it welcoming for the first-time gym goer: “Judgement Free Zone”. And because their customers don’t use advanced equipment (such as free weights or squat racks), Planet Fitness can open and operate gyms at a lower cost. This enables them to charge just $10 per month for a membership and be a cost leader in this category.
- Redbox. Before streaming was a thing, Blockbuster dominated the DVD rental market. Redbox executed a “niche + low cost” strategy by providing a smaller selection and shorter rental time to customers in exchange for lower prices. They distributed the DVDs in bright red vending machines that were placed in gas stations, grocery stores and other locations across the country. It wasn’t good if you wanted to see a very specific movie, but was a great option for impulse buyers who are open to seeing anything new.
Summary: If an incumbent has a high profit margin, there is often an opportunity to segment the market and provide a new option to the price-conscious customer. A successful cost focus strategy must have a lower cost structure to support the lower price.
Niche + Differentiated
At first glance, this seems like the easiest strategy.
Just find a group of people, make a product more specifically tailored to their needs than anything else, and charge a premium price.
But executing it well is surprisingly difficult. How much extra can you charge? How big is the subset of the market you’re targeting? Do your customers really need a special solution, or does the mainstream option (which probably has more brand awareness and other scale advantages) adequately serve their needs?
It’s not as easy as it seems!
Superhuman. There are a lot of people that use email. Superhuman had the thesis that a portion of them — those who use email a lot — would pay a lot for an email client that dramatically sped up their experience. The bet is: if Superhuman could create a product that saved customers an hour a day, $30 / month might be worth it for them.
Of course, to improve productivity for these super users, the software had to be fast. Really fast. To engineer this was no small feat - the team started writing code for it in 2015 and didn’t have a product complete until 2017 (even with 14 people!).
And not only did it have to be fast from an engineering perspective, but people had to use it quickly too. If the software was slick but users weren’t more productive, what’s the point?
To solve this, Superhuman requires each customer to have a 1-on-1 onboarding session with a Superhuman employee. In that session, users learn all the keyboard shortcuts, email templates and get to inbox zero — a first for many of them.
Superhuman doesn’t just sell software, they sell training on how to be more productive with email. Yes, it costs them something to provide, but given their high $30/mo price point, it probably pays for itself within one or two months of usage, and is key to delivering on the value they promise.
How many customers they’ll ultimately be able to attract — and whether they’ll be able to withstand discount copycats — remains to be seen.
- Financial Times. The Financial Times provides coverage of global business, politics, and culture through a paid subscription model. They target affluent readers, as shown through their $11.50 per week price. Their strategy is working. While many old media models have struggled, as of 2019 the Financial Times has over one million paid subscribers (75% of which are digital).
- Mizzen+Main.Not everyone who wears men’s dress shirts wants them to be made from stretchy, technical fabrics. Not everybody needs moisture wicking, or wants trim, athletic cuts. But there is a subset of the market that loves that, and are happily willing to pay a premium. This is the subset that Mizzen+Main is built for. They serve everyone from professional athletes to everyday guys that want something more comfortable for the office. While many of their competitors offer lower price points, by differentiating on product and market positioning, Mizzen & Main is able to charge a higher price by earning the trust of their niche.
- Canon. Before smartphone cameras got good, Canon didn’t focus on any particular niche within photography. Most of their revenue came from simple point-and-shoot cameras. Once the iPhone camera came out (with increasing quality in each iteration), sales of compact digital and D-SLR cameras went into a free fall. In order to stay alive, Canon now takes a “niche + differentiated” strategy, pivoting to develop mirrorless cameras that better serve the needs of professional and “prosumer” users. This way, they can still leverage their technical expertise by moving into a smaller but growing market (12% per year) and get out of a declining one.
Summary: By targeting a subset of a market, a company can better serve the needs of the customer. This is an especially effective strategy for small companies because they can profit in a small market but avoid competition from larger firms.
Strategy for monopolists
The four strategies really are derived from two fundamental decisions:
- Who are we serving? (Broad vs. focused)
- What do they need? (Differentiated vs. low cost)
Of course, neither of these questions actually has binary answers. What looks like a “focused” strategy today may end up becoming overly broad in the future, as firms spring up to serve ever-more-specific needs of customers. And what seems like a fundamental trade-off between low cost and premium differentiation can get pretty blurry in practice.
Take Facebook and Google, for example. Which strategy are they pursuing? In the market for advertising, they are both differentiated and low-cost relative to TV, newspapers, magazines, and podcasts.
Because they don’t need content creators, it costs them very little to generate a supply of attention. And yet, their ability to target advertisements to specific people at specific times is hugely valuable to their customers, and can’t be matched by other forms of advertising.
This is where a Michael Porter line from 1998, which he wrote the introduction to the second edition of Competitive Strategy, comes in handy:
“Sometimes companies such as Microsoft get so far ahead that they seem to avoid the need for strategic choices, but this becomes their ultimate vulnerability.”
In order to stay ahead, Facebook and Google need to ultimately pick a side: low cost, or differentiated. Do they need to offer a lower price than alternative forms of advertising, or charge a premium for advanced targeting functionality? It depends.
For now, they have a lot of option value. But if new entrants were to come into the market and threaten their position, they’d need to know which side they were on in order to respond effectively.
What about Amazon? In one sense, it’s clear that they’re pursuing a “broad + low cost” model. But their business is actually more complex than that, and it’s interesting to take note of.
Amazon isn’t just one business. It’s a company that owns hundreds of businesses. Most of these are built around the core “broad + low cost” model, but that’s not necessarily true of all of them. For example, their advertising business is actually “broad + differentiated” because people searching on Amazon have so much intent to purchase, it’s possible for them to charge a premium.
In general, the unit of analysis for strategy is the business, rather than the firm. The lines between firms, businesses, and products can get blurry, but it’s important to try and keep them separate.
This post was co-written with Adam Keesling, who is awesome. You should follow him on Twitter.
If you liked this post, press the purple “like” button so we know to do more like it :)
Also, I’d love to hear what you think! Are these four strategies really exhaustive, or can you think of companies that might be the exception to the rule? Leave a comment.