In consulting with a number of software companies, as well as working for one, it's apparent that the major software companies are trying to differentiate themselves in the minds of their potential customers. One way to look at the importance of differentiation is to look at its opposite form: commodification. Most businesses don't want their products to become commodified, which is typically associated with falling price points and vulnerability to foreign competition (cheap imports, dumping) and/or cross-subsidizing behemoths (think Wal-Mart and its loss-leader fuel centers).
One large software company I worked with focused on crafting an end-to-end solution instead of pushing product, while another focused on driving user adoption (ease of use) and shortening a customer's payback period.
These strategies became evident in the way the companies allocated resources—such as sales operations for selling solutions and new compensation structures—and how they extended their solutions (new alliances, new integration points).
Others in the software space focused on using one application suite as a loss leader to sell their core products and as a way to fragment into a new account and farm it later in the relationship.
The one constant is that each software company seemed to use a cost or differentiation strategy, separately or in combination.
In 1996, Michael Porter, a well-known strategist at the Harvard Business School, suggested in the Harvard Business Review that there are essentially three "generic" strategies:
- Cost leadership
- Cost or differentiation focus
This strategy calls for being the low-cost producer in an industry for a given level of quality. A company can sell its products either at average industry prices to earn a profit higher than that of rivals (given their lower cost structure) or below the average industry prices to gain market share (less profit and more share). Many software companies will give away (literally or at a nominal cost) their software without being a low-cost producer in hopes of establishing a beachhead, becoming the de facto standard, or selling additional value-added services or follow-on offerings.
Unlike in manufacturing, most software companies don't talk about supply-side economies of scale: the inverse relationship between the numbers of units produced and the average cost of producing each unit. Software companies typically talk about demand-side economies of scale in which the more consumers/businesses that use the software, the more it becomes the standard and the greater number of customers the development costs can be amortized over.
The software industry is similar to the pharmaceutical industry in terms of making a large investment up-front, such as development costs, and then making high profits for the life of the patent or standard. Breakthrough drugs are analogous to having proprietary code and being an ahead-of-the-curve leader. Finally, just as pharmaceutical firms can own a niche for drugs that treat asthma and allergy symptoms, PeopleSoft can be a dominant player in HR systems, for example.
The four cost leadership (and general strategy) areas to focus on are:
- What you sell. Can you develop it at a lower cost?
- Who sells it. Can you sell it through partners or avoid expensive intermediaries?
- Where you sell it. Are you targeting the right segments?
- How you sell it. Can you deliver it over the Web or through a lower-cost channel?
Additional initiatives/methods (some are more application) in using the cost leadership strategy include:
- Using a low price model (a non-cost leader bluff) as a way to penetrate a market, lock customers into your value, and then raise the cost and/or cross- and up-sell additional products and services into the satisfied account. The key here is to deliver, track, and communicate the value that has been created to build up relationship capital and to create a profitable partnership going forward.
- Use a type of versioning in selling your software in which buyers can choose the version and functionality that best meets their needs with the option of upgrading their product as their needs change.
- Change the business model by profiting from a transaction vs. an overall license arrangement. This model is what IBM is calling utility computing, in which it implicitly acknowledges that the software is a commodity, and you pay for it like a common utility such as water or electricity.
- Use the software as a loss leader to sell bigger ticket integration/implementation or value-added services. In the customer relationship management (CRM) space, one rule of thumb is that integration costs are two to three times the software license costs. Some of the larger system integration companies will give away (invest) some strategy consulting work to sweeten the eight-digit integration proposal that they ultimately want to close.
- The raw material for software development is predominately composed of labor costs such as software engineers, work that is increasingly being outsourced to India, Russia, or other offshore locations. By lowering the labor costs in developing software, a company can potentially maintain cost leadership by having a lower cost structure than its competitors. Remember that the outsourcer will have to add management, communication (travel costs), and coordination costs to its investment in evaluating this option.
- Examine how you can reuse code, software objects, and unique knowledge in being more productive and efficient in developing software. Project reuse is a common method in consulting to increase margins and economies of skill, as is code reuse in software development. It is a worthwhile effort to confirm that this area is being maximized within any software company.
- Finally, as stated above, many companies will give their software away in an attempt to create network effects and to become the de facto standard. Many will give a 30-day trial period as a variation on this strategy. Although this method is defendable in certain situations, there is clearly a perceived positive relationship between cost and quality, and, although it may not damage the customer's company, it could destroy more value than the free strategy might create.
In his article in the Harvard Business Review, Porter states, "Competitive strategy is about being different. It means deliberately choosing a different set of activities to deliver a unique mix of value." Typically, in a differentiation strategy, a company seeks to be unique in its industry along dimensions that are widely valued by buyers.
For software, those dimensions might include scalability, integratability, robustness, portability, modularity, and many more. A company will often elect one or more attributes, which many buyers in an industry perceive as important, and uniquely position itself to meet those needs. It is often rewarded for its uniqueness with a premium price and above average profits.
There are two points to focus on with regard to a differentiation strategy.
- Make sure you have a unique set of tailored activities (see activities along the value chain, such as development, sales and marketing, distribution, implementation, etc.) that cannot be easily imitated.
- Make sure that your prospects and customers can tell the difference between competitors.
Initiatives/methods (some are more application) in using a differentiation strategy include:
- Audit all of the activities that your company conducts to define, develop, distribute, deploy, and maintain your software in looking for uniqueness and competencies. Next, ask your customers what they value most in what your company, your competitors, and your type of software do for them. Survey the marketplace to find the areas of pain and the value gaps. Finally, combine your activities into a unique pattern that aligns with the customer and market value drivers in delivering on your differentiated value proposition.
- In today's economic climate, many software companies are attempting to differentiate themselves on some sort of value-based positioning. Discussions around return on investment (ROI) and total cost of ownership (TCO) are ubiquitous in most software sales calls. In terms of differentiation, these discussions suggest that X is different from Y by the value it creates once the software is purchased, deployed, and adopted. Although this is a powerful differentiator on its face, it needs to be specific (which customers?, which industries?), credible (can I speak with them?), and corroborated (how many customers achieved these results?) to be of the greatest use as a differentiating factor in closing a deal. Many ROI and TCO claims are more marketing-oriented and superficial than substantive.
- In terms of differentiation of the actual software code, areas that come to mind include its extensibility (can you build on or extend it?), its error-handling ability, the nature and frequency of the comments (is it heavily commented?), and its portability to different platforms (see the Sun and Microsoft debates). This area often gets back to the TCO case in terms of lower labor costs around maintenance, administration, and configuration.
- Use various models of decreasing risk for the customer, which ultimately can increase the risk-adjusted value of your solution. Methods of decreasing customer risk include instituting a gainsharing model (you only get a certain percentage of the gains that the customer realizes—cost savings or revenue enhancements), agreeing to specific performance guarantees or service-level agreements, and/or providing evidence that your company will be an ongoing concern (see all the software firms showcasing their strong balance sheets when they feature little debt and lots of cash).
- Another area to closely investigate is the ability of your software to integrate with legacy systems and other software/hardware products. Typically, the more compatible and integratable your software is with other systems, relative to competitors, the greater advantage you will have in the marketplace, all other things being equal.
- Look at your ability to sell and deliver an end-to-end solution. This capability may be important to some customers depending on the definition, but in terms of a total front-to-back software solution (see Oracle for back-, mid-, and front-office), it could be viewed as increasing a customer's vendor risk (all eggs in one basket). Nevertheless, having an extensive partner ecosystem and/or the ability to offer strategy-to-implementation-to-help-desk services may be a key differentiator in some competitive situations.
The strategy of focus rests on the choice of a limited competitive scope within an industry. Focus strategists select one or more segments in their industries and tailor their strategies to serving those segments to the exclusion of others.
The focus strategy has two variants.
- In cost focus, a firm seeks a cost advantage in its target segment.
- In differentiation focus, a firm seeks differentiation in its target segment.
These generic strategies are not necessarily discrete. They often bleed into each other and, like most categorical schemes, there are numerous exceptions, as well as criticisms, around being too simple or incomplete. Similar to most business tools or mental models, the strategies should be analyzed and applied in a way that is fitting with the situation and in line with other information that confirms or disconfirms a particular business hypothesis. Similar to zero-based budgeting—in which each specific line item is justified with a business case—each strategy should be tested in a similar manner with a clear outline of all assumptions, risks, sensitivities, and costs/benefits. It is only through enlightened trial-and-error and strategic adaptation that software companies will improve, grow, and thrive in an increasingly unforgiving marketplace.
TechRepublic originally published this article on 29 October 2003.