What Is a Competitive Advantage?
Competitive advantage refers to factors that allow a company to produce goods or services better or more cheaply than its rivals. These factors allow the productive entity to generate more sales or superior margins compared to its market rivals. Competitive advantages are attributed to a variety of factorsincluding cost structure, branding, the quality of product offerings, thedistribution network, intellectual property, and customer service.
Key Takeaways
- Competitive advantage is what makes an entity's products or services more desirable to customers than that of any other rival.
- Competitive advantages can be broken down into comparative advantages and differential advantages.
- Comparative advantage is a company's ability to produce something more efficiently than a rival, which leads to greater profit margins.
- A differential advantage is when a company's products are seen as both unique and of higher quality, relative to those of a competitor.
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Understanding Competitive Advantage
Competitive advantages generate greater value for a firm and its shareholdersbecause of certain strengths or conditions. The more sustainable the competitive advantage, the more difficult it is for competitors to neutralize the advantage. The two main types of competitive advantages are comparative advantage and differential advantage.
A comparative advantage is when a firm can produce products more efficiently and at a lower cost than its competitors.
A differential advantage iswhen a firm's products or services differ from its competitors' offerings and are seen as superior. Advanced technology, patent-protected products or processes, superior personnel, and strong brand identity are all drivers of differential advantage. These factors support wide margins and large market shares.
For example, Apple is famous for creating innovative products, such asthe iPhone, and supporting its market leadership with savvy marketing campaigns to build an elite brand. Another example is major drug companies. They can market branded drugs at high price points because they are protected by patents.
Competing on price can be effective, but if you slash prices too much you risk decreasing profit margins to an untenable level. Many firms opt instead to differentiate themselves in other ways, which helps preserve or expand their profit margin.
Note
The term "competitive advantage" traditionally refers to the business world, but can also be applied to a country, organization, or even a person who is competing for something.
Competitive Advantage Areas
To build a competitive advantage, a company can use one of three main methods:
- Cost: Provide offerings at the lowest price
- Differentiation: Provide offerings that are superior in quality, service, or features
- Specialization: Provide offerings narrowly tailored to a focused market
How to Build a Competitive Advantage
To build a competitive advantage, a company must know what sets it apart from its competitors and then focus its message, service, and products with that difference in mind. Here are several strategies companies use to build a competitive advantage:
- Research the market: Market research helps a company identify and define its target market, which can guide it in developing the most effective advantage.
- Identify strengths: A company can find its unique strengths, especially relative to competitors, by reviewing products, services, features, positioning, and branding.
- Evaluate finances: Companies can take a close look at their financial performance to spot profit centers and areas of stability, using financial statements and ratios.
- Review operations: How efficient is a company's operations? Where is it effective, and where is there room for improvement? Consider customer service as well as production and supply chain management.
- Research and development (R&D): Securing intellectual property prohibits competitors from using processes or know-how that the company can use to produce products competitors can't legally copy.
- Consider human resources: The talent a company can attract as employees and leadership can make an important difference in the success of the business. Evaluating company culture, hiring, and staffing practices can help.
Competitive Advantage vs. Comparative Advantage
A firm's ability to produce a good or service more efficiently than its competitors, which leads to greater profit margins, creates a comparative advantage. Rational consumers will choose the cheaper of any two perfect substitutes offered.
For example, a car owner willbuy gasoline from agas station that is 5 cents cheaperthan other stations in the area. For imperfect substitutes, like Pepsi versus co*ke, higher margins for the lowest-cost producers can eventually bring superior returns.
Economies of scale, efficient internal systems, and geographic location can also create a comparative advantage.
Comparative advantage does not imply abetter product or service. It only shows the firm can offer a product or service of the same value ata lower price.
For example, a firm that manufactures a product in China may have lower labor costs than a company that manufactures in the U.S., so it can offer an equal product at a lower price. In the context of international trade economics, opportunity costdetermines comparative advantages.
Amazon (AMZN)is an example of a company focused on building and maintaining a comparative advantage. The e-commerce platformhas a level of scale and efficiency that is difficult for retail competitors to replicate, allowing it toriseto prominence largely through price competition.
How Do I Know if a Company Has a Competitive Advantage?
If a business can increase its market share through increased efficiency or productivity, it will have a competitive advantage over its competitors.
How Can a Company Increase Its Competitive Advantage?
Lasting competitive advantages tend to be things competitors cannot easily replicate or imitate. Warren Buffet calls sustainable competitive advantages economic moats, which businesses can figuratively dig around themselves to entrench competitive advantages. This can include strengthening one's brand, raising barriers to new entrants (such as through regulations), and the defense of intellectual property.
Why Do Larger Companies Often Have Competitive Advantages?
Competitive advantages that accrue from economies of scale typically refer to supply-side advantages, such as the purchasing power of a large restaurant or retail chain. But advantages of scale also exist on the demand side—they are commonly referred to asnetwork effects.This happens when a service becomes more valuable to all of its users as the service adds more users. The result can often be a winner-take-all dynamic in the industry.
How Is Competitive Advantage Different From Comparative Advantage?
Comparative advantage mostly refers to international trade. It posits that a country should focus on what it can produce and export relatively the cheapest—thus if one country has a competitive advantage in producing both products A & B, it should only produce product A if it can do it better than B and import B from some other country.
The Bottom Line
A company's competitive advantage is the way it excels compared to its rivals. This advantage may be through cost leadership, differentiation, or focus. Identifying a company's competitive advantage helps show how it is positioned to be more successful than its competitors, creating more revenue and generating greater profits.
