When differentiation strategy works best

At one point or another every business owner considers different strategy types and stumbles across the work of Michael Porter. He defined three generic strategies. One of which being differentiation. But when should you actually implement a differentiation strategy?

There are four factors when a differentiation strategy works best. The first one is a market with customers who aren’t price-sensitive. The second is a lot of competition. Thirdly, customers have diverse needs. And the last one is a supplier with a strategic resource that is hard to copy.

You also have to know that these factors work in conjunction. That means having one in a market  isn‘t enough. And of course, there is more to the story than a few qualities of a market situation.

What is a differentiation strategy?

Differentiation is the strategic direction of designing product and service qualities markedly different than competitors in order to command a price premium or higher customer loyalty.

The other side of the coin is, that these differences have to matter to the companies target customers. If that is not achieved, there is no differentiating effect.

Differentiation is one type of generic strategy that firms can adopt. Usually it doesn‘t work under all market conditions or for any company. Also, it is more than just a marketing strategy to highlight differences in an offer. Other activities that are part of a differentiation strategy usually include:

  • targeting a specific buyer segment that is less sensitive to high prices and underserved by the competition
  • giving up the possible strategic choice of cost leadership, as it is close to impossible to achieve above average appeal for the chosen buyer segment whilst still producing cheaply
  • aligning company processes like purchasing, production, marketing and sales to serve the target group
  • creating, using and defending the strategic resource that is paramount to the differentiating quality (for example: brand, knowledge about customers, production technology, …)

When would a business use a differentiation strategy?

There is one main condition under which a company would use a differentiation strategy. Apart from the right market conditions, the company needs to be able to generate more or a different value for customers. If there is no competitive advantage to serve a group better than the competition, differentiation does not work. 

It is hard to judge up front when the conditions call for a differentiation strategy. To shed some light on the nuance of this decision, I prepared the following table with factors to consider. The factors probably never show up completely or all at once. So eventually, it is a judgement call.

SituationRight or wrong?Comment
Many competitorsNiche strategy also applicable
Commodity-like product/serviceDepending on product, differentiation could still work
Company has cost advantagein most cases, differentiation destroys cost advantage
Customers needs are diversein the app market it would still be almost impossible to set premium prices
Good/Service is of small importancethe result is, that customers care less about brand or loyalty, however there are also less price sensitive
Rapidly growing marketThere is a general surge in demand and too little supply-> customers do not care much where they buy
Saturated marketthere is a strong necessity for differentiation
Special knowldege of customerscompetitive advantage
Special skill set to produce/servecompetitive advantage
When to use differentiation

There are many more thoughts that have to go into the strategic decision. The problem is not to see one factor and decide. The problem usually is that there are many contradicting factors. For example:

Should a company with special knowledge of customers in a stable market with lots of competitors and a commodity-like service attempt to use a differentiation strategy?

Unfortunately, there is no right answer in general. It depends on the specific product, the specific knowledge and the specific competitors.

Why differentiation is important in business?

Differentiation is important in two ways. First, there is a need to do some differentiation in every market, so the offer of the competition is matched. There is no market without this effect. Second, differentiation in the true sense serves your target segment better than the competition, hence the product is prefered by some customers. This generates profits for the supplier.

There have been studies conducted that found differentiation strategies among the more robust ways of generating profits. My guess is, because it is generating more (subjective) value for customers. 

Especially, regarding this last point I wrote an article about „What makes strategy successful?“, in which generating value for customers is regarded as the factor with the second largest impact on profits.

The linked to study shows that differentiation is not the most profitable way (that is a niche strategy). But it references other research in it’s conclusion that it can be as effective as a niche strategy for small businesses. 

(Although, according to Michael Porter‘s work a differentiation strategy under his definition seemed to me more set up for bigger companies. 🤓)

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