The objective of differentiation is to create a position in the marketplace which is unique. Rather than engaging in price competition, a firm pursuing a differentiation strategy aims to create a defensible competitive position based on non-price factors. In industries where there are many sellers and relatively homogenous products, differentiation is critical to avoiding price competition.
Before talking about differentiation, it is, of course, possible to compete through a cost advantage strategy. Achieving the lowest cost structure in an industry allows a firm to extract a higher margin or price lower than rivals. However, it is not easy to achieve an industry-leading cost structure, and such competitive positions can rarely be maintained as the sources of lower costs can often be copied by rivals. Lower input costs (i.e., raw material costs) are always preferable but are rarely the source of an enduring cost advantage. Unless the supply of these inputs is protected under some sort of exclusive arrangement, these lower input costs may be replicated by rivals. In addition, cost advantages are rarely created by lower input costs alone; rather, they are often created by exploiting economies of scale, economies of learning, standardized product design, or the ability to rapidly flex capacity in response to changes in market demand.
Secondly, differentiation is about creating meaningful differences, not better sameness. The degree to which a firm can successfully differentiate itself allows that firm to gain some market power and achieve a markup over cost. Where differentiation is weak, price competition will prevail and markups over marginal cost will be small. Where differentiation is strong, price premiums can be charged and markups over marginal cost will be correspondingly larger. A key point to note is that successful differentiation allows an optimal pricing strategy, which is a proportional markup over marginal cost that is independent of other firms’ pricing strategies. Thus, with good differentiation, prices can be maintained no matter what pricing strategy rivals adopt.
However, differentiation doesn’t just allow a firm to charge a higher markup and achieve a higher margin. Equally important, differentiation desensitizes the customer to competitive offerings. When a customer perceives that the value being offered is in some way distinct and superior, that customer becomes less willing to substitute a competitive offering, even if that offering has a lower price. Thus, differentiation can make a firm’s demand curve less elastic.
A final point to make: differentiation can be achieved without altering the product itself. While making physical changes to a product can be a source of differentiation, the same effect can sometimes be achieved by creating, in the customer’s mind, a different perception of the value being offered. This is especially important for “commodity” type products where it may not be possible to make physical changes to the offering. Thus, how the product is described and marketed to the customer may, in itself, be a source of differentiation.
Other sources of differentiation beyond the physical product can be brand (or image), service (sometimes bundled with the product), and personnel. It is interesting to note that quality is often misused as a differentiating factor. For many customers, what is important is quality parity among suppliers, where a certain level of quality is expected. However, these same customers may not necessarily be willing to pay for additional levels of quality.
It may even be that, in some cases, differentiation doesn’t even have to meaningful to succeed. For example, Alberto Culver makes a shampoo called Natural Silk to which it does add silk, despite admitting in an interview that silk does nothing for hair. But offering and promoting this product attribute attracts attention, creates a distinction, and implies a better working formula which, in turn, attracts customers.