Competitive Advantage Definition With Types and Examples

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 others in its market.

Competitive advantages are attributed to a variety of factors including cost structure, branding, the quality of product offerings, the distribution network, intellectual property, and customer service.

How a Competitive Advantage Works

Competitive advantages generate greater value for a firm and its shareholders because 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 is when 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.

Apple is famous for creating innovative products such as the iPhone and supporting its market leadership with savvy marketing campaigns to build an elite brand. Major drug companies are another example. They can market branded drugs at high price points because they're protected by patents.

Competing on price can be effective but you risk decreasing profit margins to an untenable level if you slash prices too much. Many firms opt to differentiate themselves in other ways instead which helps preserve or expand their profit margin.

Competitive Advantage Areas

A company can use one of three main methods to build a competitive advantage:

• Cost: They provide offerings at the lowest price.
• Differentiation: They provide offerings that are superior in quality, service, or features.
• Specialization: They provide offerings that are narrowly tailored to a focused market.
  

How 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. Companies can use several strategies to build a competitive advantage:

• Research the market: Market research helps a company identify and define its target market and this 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 the company can use to produce products that 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 leads to greater profit margins and creates a comparative advantage. Rational consumers will choose the cheaper of any two perfect substitutes that are offered.

A car owner will buy gasoline from a gas station that's five cents cheaper than other stations in the area. Higher margins for the lowest-cost producers can eventually bring superior returns for imperfect substitutes like Pepsi versus Coke.

Economies of scale, efficient internal systems, and geographic location can also create a comparative advantage.

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. Opportunity cost determines comparative advantages in the context of international trade economics. 

Amazon (AMZN) is an example of a company that's focused on building and maintaining a comparative advantage. The e-commerce platform has a level of scale and efficiency that's difficult for retail competitors to replicate, allowing it to rise to prominence largely through price competition.

The Bottom Line

A company's competitive advantage is the way it excels compared to its rivals. This advantage might be through cost leadership, differentiation, or focus. Identifying a company's competitive advantage helps show how it's positioned to be more successful than its competitors, creating more revenue and generating greater profits.