Competitive advantage is when a company does business better than their competitors. Not only having excellent operating performance, but these advantages are also reflected in their finances. The company earns higher than the average profitability for all companies in the industry.
Not all companies can do it. In this article, we will review what competitive advantage is, why it matters, and how we identify it. And, we also discuss two important concepts to explain the source of competitive advantage.
What is a competitive advantage?
Competitive advantage is a condition in which a company is superior compared to its competitors. The company successfully implemented a value creation strategy. And, competitors cannot or are too expensive to duplicate these advantages.
Competitive companies usually have one or more of the following characteristics:
- Higher profitability and return on invested capital (ROIC) than the average competitor
- Lower cost structure
- Strong brand equity
- High customer loyalty
- Offering high-quality products
- Extensive and effective distribution network
- Innovative and superior in intellectual property
- Excellent customer service
- Better proprietary technology
- Favorable price
- Better productivity
- Unique resources
When a company can maintain its advantage over a long period, that is a sustainable competitive advantage.
Why competitive advantage is important
For businesses, competitive advantage is the primary goal. Companies will find it challenging to survive profitably when they are uncompetitibe. And, once having it, they always try to maintain these advantages.
Competitive advantage is not permanent. It can change because of, for example, changes in the business environment. And when a business cannot adapt and change its strategy, competitors can surpass it.
Competitive advantage depends on the speed of competitors to surpass the company. This speed determines how long a competitive advantage will last. Competitors could obtain the skills needed to compete effectively. They can duplicate the benefits of a company’s value creation strategy so that it goes beyond what already exists.
For consumers, competitive advantage means company products can satisfy their needs. When companies compete for competitive advantage, it increases consumers’ choices for cheaper or better quality products.
For bond investors, superior companies offer better returns. They have a low default risk because they can repay loans and interest. For stock investors or shareholders, excellent performance is translated into higher dividends, higher capital gains, or a combination of both.
How companies build a competitive advantage
In this section, we will briefly discuss two concepts to explain how a company build a competitive advantage. The two thoughts are:
- Generic strategy by Michael Porter
- Resource-based view initiated by Jay Barney
Porter’s generic strategies
Porter identifies two sources of competitive advantage:
- Cost advantage through cost leadership
- Price advantage through differentiation
Companies create value when they can satisfy customers in the same way as competitors, but more efficiently. In other words, companies offer relatively similar products or services. They are no different from competing products. But, to produce these products and services, the company has a lower cost structure than the average competitor. That’s what Porter calls cost leadership.
The opposite side is a unique and differentiated offering. The company offers products and services that customers are willing to pay more for. Customers really want it. And in some cases, the higher the price, the higher the value and satisfaction that the customer gets. In economics, such products are known as Veblen goods. Consumers become loyal and even willing to queue up to buy the latest version.
Differentiation does not mean only focus on products and services. The company could offers more value to consumers through related services. For example, the company provides better after-sales services. Such services justify higher prices. Also, branding and advertising contribute to differentiation.
Furthermore, companies can apply those two strategies to two different types of target markets: broad markets and narrow markets (niches). More specifically, for niche markets, Porter named it a focus strategy.
The following are two examples of companies that implement these two strategies:
- Cost leadership strategy: Walmart, McDonald’s
- Differentiation: Apple, Louis Vuitton, Tesla
This concept views that to create a competitive advantage, it depends on the company’s resources and capabilities. When successfully utilizing both, the company can produce superior value creation.
Resources are company-specific assets that are not or few owned by competitors. The company utilizes these assets to create a cost advantage or differentiation. Examples of these resources are patents, intellectual property, brand equity, company reputation, and control of unique raw material sources.
Capability is about the company’s ability to use its resources effectively. Examples of these capabilities are inspirational leadership, agility and speed, customer focus, and innovation.
In contrast to resources, capabilities are difficult to replicate. It is embedded in organizational routines and is not easily documented as a procedure.
Together with resources, capabilities form core competencies. It is this competency that contributes to creating superior value propositions.
How do we know a company has a competitive advantage
The reward for creating superior value is profitability and market share. But, for the latter, a significant market share is not always profitable. Those statistics only tell us how strongly the company dominates the market. For this reason, we should not use market share to measure competitive advantage.
ROIC is a quantification of competitive advantage
In general, a superior company has higher profitability than competitors. In textbooks, return on invested capital (ROIC) is the indicator. This ratio reflects the return investors get when they invest their money in the company. So, the company will produce an ROIC that is higher than the industry average when it has a competitive advantage.
Then, to find out why the company has a higher ROIC, you can explore it from the ROIC component. Of course, if you have time to do it.
Interestingly, Michael Porter has submitted an answer to the primary source of profitability. That is a higher price, a lower cost, or a combination of both. Why prices and costs?
Because basically, profitability is a function of revenue and costs. The more significant the difference between the two, the more profitable the company.
With an identical cost structure, higher revenue results in higher profits. Then, revenue is high when companies can charge premium prices for their products and services.
Likewise, assuming the company has a relatively equal nominal revenue (as well as the price offered), the company is profitable when it has a lower cost structure.
Profitability will be even higher when revenue is higher, and the costs are lower. But, often, both have trade-offs. And, companies find it challenging to achieve both at the same time.
ROIC is not an absolute number, it varies between industries
It would be best if you remembered, competitive advantage is always relative, not absolute concept. That means to judge a company is superior or not, we must compare the company’s performance with benchmarks. The standard is usually the industry average or peer companies in the same industry.
ROIC measures, as well as competitive advantages, vary between industries. So, you cannot use these statistics for all sectors. For example, The ROIC of the pharmaceutical industry could be higher than that of the media industry or the food and beverage industry, as McKinsey found for a company in the United States. So, you cannot compare the competitive advantage of pharmaceutical companies with food producers.