Why Does a Differentiation Strategy Improve Profitability?
Strategy
February 16, 2022

Why Does a Differentiation Strategy Improve Profitability?

Gaussian Team

In a previous article, we provided a clear definition for differentiation strategy. And described how there are primarily two differentiation approaches an organization can take: Broad vs. focused.

But how does a differentiation strategy impact the bottom line? In this article, we discuss three key ways that a well-differentiated offering improves profitability, using examples from authoritative industry-leaders to provide further context.

If an organization’s product or service is differentiated, it means that they are either addressing a previously unaddressed pain point, or they are addressing the pain point in a unique and better way. This differentiation unlocks several market opportunities that improve profitability.

1. Easier to acquire new customers

When an organization’s product or service offers a better or new solution to a major pain point, it enables you to attract more customers. And, a differentiated offering allows you to tap into new markets that may not be readily available without that differentiation. In both cases, the cost of acquiring a customer is lower and marketing efficiency is higher, driving higher per-customer profitability.

Additionally, when customers are satisfied because an offering meets their needs, those satisfied customers will often advocate the offering to others. Such social proof and existing customer referrals enables further customer growth.

Slack is an example of a firm that found enormous customer growth by differentiating itself. As Slack CEO Stewart Butterfield famously explained prior to their product release, Slack didn’t sell “saddles,” they sold “horseback riding.” Slack focused on customer-centric differentiation before the product was even launched: delivering innovation that their customers needed, rather than selling a product. They recognized that their product would allow their customers to see “a dramatic shift in how time is spent, how communication happens, and how the team’s archives are utilized.” And by closely aligning their offering to customer needs, they delivered explosive customer growth simply by being a product that customers loved - so much so that customers were willing to refer their friends and colleagues.

2. Able to command a premium price in the market

When a product or service is sufficiently differentiated, and thereby solves a new or existing pain point in an innovative way, customers are willing to pay a premium for it. The bigger the pain point that you solve, the more customers are willing to pay.

Successful organizations use a differentiation strategy to offer quality products and customer service, which allows them to demand a higher price. Apple differentiated itself from the beginning by focusing on being a premium, high quality product. In turn, Apple has been able to charge premium prices for its products – with consumers sometimes standing in line for hours for the privilege of buying an expensive hot new product.

Oracle’s approach to differentiation is the counterexample to HubSpot’s: both pursue a focused differentiation strategy and even have products that serve the same target market, but unlike HubSpot, Oracle focuses on the enterprise market. Knowing that enterprise companies prefer proven technology over smaller and unproven entrants, Oracle has built a reliable customer base among the largest companies. With its focused differentiation strategy, Oracle is able to charge a premium price for its products to a customer base that is willing to pay for a product that meets its expectations. As a result of its differentiation, Oracle consistently maintains profit margins exceeding 25%. And unlike HubSpot, you won’t see freemium or free trial offerings with Oracle – in fact, Oracle offers little in the way of price transparency at all, because they do not need to.

Studies have found that a differentiation strategy leads to more sustainable profitability than if an organization focuses solely on implementing a cost leadership strategy. It’s not just short-term profitability that benefits from differentiation, but long-term as well.

3. Higher customer loyalty and retention

A successful differentiation strategy allows a firm to earn customer loyalty because consumers become attached to their differentiated features. By uniquely solving for customer needs, an offering becomes more valuable to customers, reducing the risk of churn and increasing their loyalty.

When an organization offers greater convenience, superior customer service, or more helpful features, consumers will be more apt to stay with a product or service than switch to a competitor. The result is improved customer loyalty and increased customer retention, which leads to larger basket size/AOV, larger lifetime value, and therefore higher margins.

What is a real-world example of a successful differentiation strategy?

To bring context to how important customer needs are for your offering’s profitability, take a close look at 3M. While a well known brand, 3M isn’t necessarily a company one thinks of when thinking about differentiated, profitable, and successful companies. Yet 3M is ranked #95 on the Fortune 500 list, generating $32 billion in annual revenue and averaging a 51% gross margin over 20 years.

3M had humble beginnings as a mining company that slowly expanded, and today offers more than 60,000 products. Its growth can be attributed to the company’s heavy focus on differentiation through product leadership. They drive innovation by identifying customer needs in the market and taking the lead in delivering unique products that solve those needs. In fact, in 2013, 3M’s CEO reported that 34% of revenue came from products created within the last five years.

The firm has focused on creating an internal innovation mindset that puts customer problems at the forefront. By focusing on solving customer needs with leading-edge products, 3M can sell into a customer base that’s less price sensitive. This results in 3M seeing benefits from all three of the pillars that drive profitability from differentiation.

First, 3M can acquire new customers by uniquely solving problems that its competitors do not solve. Second, 3M can charge a price premium for these products, since they are often state-of-the-art and address unsolved pain points. Finally, 3M is able to better retain customers by building loyalty as a result of their intense cultural focus on the customer.

To bring context to how important customer needs are for your offering’s profitability, take a close look at Tesla. Elon Musk and the rest of Tesla’s executive team saw pain points of gas prices, limited range, and a consumer desire to become environmentally friendly. And while the market had certain entrants with electric vehicles, none offered a vehicle that offered a comparable driving experience to what consumers expected from their traditional car

Want to learn how to create an effective product differentiation strategy? Find out in this article.

With these needs in mind, Tesla disrupted the automotive industry by creating long-range electric cars focused entirely on an exceptional customer experience. Tesla clearly identified a unique customer need and invested heavily in offering a range of vehicles that solved them.

Due to the way Tesla has uniquely solved these pain points, customers are willing to buy them over other cars. Tesla’s intense focus on differentiation not only prompted consumers to switch their electric car preferences, but Tesla also managed to drive consumers who were loyal to gasoline to switch. Again, this was able to happen because the market finally offered an electric car where the consumer didn't have to make sacrifices for their needs.

Additionally, Tesla has been able to command a premium price and still gain market share. Tesla continues to raise prices and still faces demand that exceeds its capability to produce new cars. Their differentiation strategy enabled them to drive market demand and deliver enormous profitability.

Eventually, other car manufacturers will catch up and develop their own strategies to address those same needs and new ones over time. To remain profitable, Tesla will need to constantly address their base customer needs and innovate their differentiation strategy.

A Profitable Differentiation Strategy Stems from Customer Needs

An effective differentiation strategy is a plan to maximize the impact of your offering by developing it around customer needs. By satisfying customer’s pain points, organizations ensure that their product or service will acquire customers, improve profitability, and increase loyalty and retention.

It’s key to keep in mind that strategies cannot stay still. Organizations’ understanding of customers should and will continue to evolve over time, as will market pressures due to competitive actions. A successful differentiation strategy will evolve concurrently.

Need help better understanding your customers as part of your strategy, or creating a differentiation plan that executes on those differentiators? Discover how our team at Gaussian can help.

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