Understanding Michael Porter, by Joan Magretta

Joan Magretta is a former partner of consulting firm Bain & Co, a former strategy editor of the Harvard Business Review (HBR), an author on strategy and general management, and a senior associate at the Harvard Business School Institute for Strategy and Competitiveness (ISC). She has collaborated with Michael Porter for two decades, both at HBR and ISC.

Below are the key lessons from her book Understanding Michael Porter:

Introduction

• Michael Porter tackled the biggest question in business: “Why are some firms and industries more profitable than others?”
• He then tackled other big questions: “Why are some countries more successful than others?”.
• Trained in the HBS tradition of case studies and field research school and in the economics tradition of building models, Porter took a different path, creating “frameworks” focused on timeless principles (e.g. higher profits require higher prices or lower costs, industry competition is driven by the five forces, the firm is a collection of activities).
• Porter’s work is the foundation of strategy, but too many practitioners get their Porter second hand and end up with inadequate and inaccurate ideas.

What is competition?

The right mindset

• Superior performance comes from:
  1. The structure of the industry in which competition takes place.
  2. The company’s relative position within its industry.
• Strategy explains how an organization, faced with competition, will achieve superior performance.
• A good competitive strategy will result in sustainably superior performance.
• The key to competitive success lies in an organization’s ability to create unique value.
  • Instead of competing to be the best, companies should compete to be unique. This means choosing a path different from others.
  • The focus should be on creating superior value for the chosen customers, not on imitating and matching rivals.
• In the vast majority of businesses, there is simply no such thing as “the best”, as:
  1. Different customers have different needs.
  2. The best functional performance depends on what you are trying to accomplish.
  3. If rivals all start to look alike, customers are left with nothing but price as the basis for their choices.
• Economies of scale are exhausted at a small share of industry sales:
  • Firms only have to be “big enough“.
  • This rarely means they have to dominate.
• Winner-takes-all thinking pushes firms to damage their performance:
  1. Price cuts to gain volume.
  2. Overextension to serve all market segments.
  3. Overpriced M&A).
• A better analogy for competition than war or sports might be the performing arts:
  • There can be many good singers or actors, each outstanding and successful and distinctive way, and each with a different audience.

The five forces

Business competition is about the struggle for profits

• The real point of competition is not to beat rivals nor to win a sale.
• The point is to earn profits.

This struggle for profits involves five forces

Porter has found that:

• The same forces are at work in different industries.
  1. Existing rivals.
  2. Customers.
  3. Suppliers.
  4. Substitute producers.
  5. Potential new entrants.
• These five forces determine the industry’s structure, i.e., how the industry works.
• Industry structure determines profitability, i.e., how the industry creates and shares value.
• Industry structure is surprisingly sticky.

The five forces determine average industry profitability

• The math of profitability is simple: Unit profit margin = price – cost.
  • Cost include all of the resources used in competing, including the cost of capital.
  • Price reflects how customers value the offering, what they are willing to pay.
  • If industry doesn’t create much value for its customers, prices will barely cover costs.
  • If the industry creates a lot of value, then structure becomes critical in understanding who gets to capture it.
  • Price is impacted by substitutes, threat of entry, buyer power, and rivalry.
  • Cost is impacted by supplier power, and rivalry.
• Each force has a clear, direct, and predictable relationship to industry profitability.
  • The more powerful the force, the more pressure it will put on prices or costs or both, and therefore the less attractive the industry will be to its incumbents.

• The collective strength of the five forces determines the average profitability of the industry through their impact on:
  1. Prices.
  2. Cost.
  3. The investment required to compete.

The five forces framework is the place to start to assess or formulate strategy

• Before Porter, the prevailing framework for sizing the environment was called SWOT.
  • Its intent was correct.
  • But the tool was weak, biased toward confirming managers’ long-standing beliefs.
• Using five forces analysis simply to declare that an industry is attractive or unattractive misses its full power as a tool.
• Industry structure can “explain” the income statements and balance sheets of companies in the industry.
• Insights gained from it should lead directly to decisions about where and how to compete.
  1. Why is current industry profitability what it is? What’s propping it up?
  2. What’s changing? How is profitability likely to shift?
  3. What limiting factors must be overcome to capture more of the value you create?
  4. Can you position your company where the forces are weakest?
• The five forces framework answers the questions:
  1. “What’s going on out there in your industry?
  2. Of the many things that are happening, which ones matter for competition?
  3. What deserves your attention?”

Buyers

• Powerful buyers will force prices down or demand more value in the product, thus capturing more of the value for themselves.
• When you assess buyer power, the channels through which products are delivered can be as important as the end users, particularly when the channel influences the purchase decisions of end-users.
• Buyers are more likely to exercise their negotiating leverage if they are price sensitive.
• This tends to happen when what they are buying is:
  1. Undifferentiated.
  2. Expensive relative to their other costs or income.
  3. Inconsequential to their own performance.

Suppliers

• Powerful suppliers will charge higher prices or insist on more favorable terms, lowering industry profitability.
• When analyzing suppliers, be sure to include all of the purchased goods that go into a product or service, including labor.
• Both suppliers and buyers tend to be powerful if:
  1. They are large and concentrated relative to fragmented industry.
  2. The industry needs them more than they need the industry.
  3. Switching costs work in their favor.
  4. Differentiation works in their favor.
  5. They can credibly threaten to vertically integrate.

Substitutes

• Products or services that meet the same basic need in a different way put a cap on industry profitability.
• They often come from unexpected places, making them difficult to anticipate or even to see once they appear.
• To assess the threat of the substitutes:
  1. Look to the economics, specifically to whether the substitute offers an attractive price-performance trade-off relative to the industry’s product.
  2. Substitutes gain ground when buyers face low switching costs.

New entrants

• Entry barriers protect an industry from newcomers who would add new capacity and seek to gain market share.
• The threat of entry:
  1. Caps prices, as a higher prices would make entry too attractive.
  2. Raises costs, as incumbents have to spend more to satisfy their customers.
• To size up the threat of new entry, ask the following questions:
  1. Will customers incur any switching cost in moving from one supplier to another?
  2. Does the value to customers increase as more customers use a company’s product (network effect)?
  3. What is the price of admission for a company to enter the business? How large are the capital investments, and who might be willing and able to make them?
  4. Do incumbents have advantages independent of size that new entrants cannot access?
  5. Does government policy restrict or prevent new entrants?
  6. What kind of retaliation should a potential entrant expect should it choose to enter the industry? Is the industry known for making it tough for newcomers? Does the industry have the resources to compete aggressively? If industry growth is slow or the industry has high fixed costs, incumbents will typically fight hard to retain their share of the market.

Rivalry

• When rivalry among the current competitors is intense, profitability will be lower.
• Incumbents will compete away the value they create by:
  1. Passing it onto buyers through lower prices, or
  2. Dissipating it in higher costs of competing.
• Rivalry can take a variety of forms:
  1. Price competition.
  2. Advertising.
  3. New product introductions.
  4. Increased customer service.
• Rivalry is likely to be greatest if:
  1. The industry is composed of many competitors or of competitors of roughly equal size and power.
  2. Slow growth provokes battles over market share.
  3. High exit barriers prevents companies from leaving the industry.
  4. Rivals are irrationally committed to the business, that is, financial performance is not the overriding goal.
• Price competition, which is the most damaging form of rivalry, is most likely when:
  1. It is hard to tell one rival’s offerings from another and buyers have low switching costs.
  2. Rivals have high fixed costs and low marginal costs, creating the pressure to drop prices as new customers contribute to covering overhead.
  3. Capacity must be added in large increments, leading to price cutting to fill capacity.
  4. The product is perishable.

Key steps in industry analysis

1. Define the relevant industry by both product and geographic scope.
2. Identify the players constituting each of the five forces and, where appropriate, segment them into groups.
3. Assess the underlying drivers of each force:
   • Which are strong?
   • Which are weak?
   • Why?
4. Step back and assess the overall in the structure.
   • Which forces control profitability?
   • Are the results consistent with the industries profitability?
   • Are the more profitable companies better positioned in relation to the five forces?
5. Analyze recent and likely future changes for each force.
   • How are they trending?
   • Looking ahead, how might competitors or new entrants influence industry structure?
6. How can the firm position itself in relation to the five forces?
   • Can it find a position where the forces are weakest (as Paccar did with individual owner-operators of trucks)?
   • Can it exploit industry change?
   • Can it reshape structure in its favor?

Industry structure is dynamic, not static

• When doing an industry analysis, you are taking a snapshot of the industry at a point in time, but you are also assessing trends in the five forces.
• Five forces analysis can help anticipate and exploit structural change.

Competitive Advantage

Performance

• Performance must be defined to reflect the purpose of every organization: to produce goods or services whose value exceeds the sum of the costs of all the inputs, in other words, to use resources effectively.
• The financial measure that best captures this idea is ROIC, measured over a full investment cycle.
  • Return on sales and growth fail to account for the capital required to compete.
  • Stock price is a measure of economic value only over the long run.
• In a business with little capital, other measures of effective resources use may be required.
  • For example, a consulting firm might measure returns per partner.

Sources of performance

• A firm’s performance has two sources:
  1. Industry structure: the five forces framework focuses on drivers of industry profitability and explains industry average price and cost.
  2. Relative position: the value chain framework focuses on differences in activities and explains relative price and cost.
• Industry structure determines the performance any company can expect just by being an average player.
• Competitive advantage is about superior performance.

Competitive advantage is about superior value

• For Porter, competitive advantage is about creating superior value.
• A good strategy produces a P&L better than the average industry baseline.
• Those differences can take two forms: (1) Be better at performing the same configuration of activities (“operational effectiveness” for Porter, “best practice” or “execution” for most managers) or (2) Choose a different configuration of activities (“strategy”).
• If you have a real competitive advantage, it means that compared with rivals, you:
  1. Operate at a lower cost.
  2. Command a premium price.
  3. Or both.
• Strategy choices aim to shift relative price or relative cost in a company’s favor.
• Where the spread between relative price and relative cost is positive, the strategy has by definition created competitive advantage.

Relative price

• A company can sustain a premium price only if it offers something that is both unique and valuable to its customers.
• Create more buyer value and you raise willingness to pay (WTP).
• In industrial markets, buyer value can usually be described in economic terms (e.g. labor cost savings).
• In consumer markets, buyer value may also have an economic component (e.g. convenience), but is more likely to have an emotional dimension (e.g. trust engendered by a brand, status).
• For Porter, differentiation refers to the ability to command a higher relative price.

Relative cost

• The second component of superior profitability is relative cost, i.e. you manage to produce at a lower cost than your rivals.
• To do so, you have to find more efficient ways to create, produce, deliver, sell, and support your product or service.
• Your cost advantage might come from lower operating costs or from using capital more efficiently (including working capital), or both.
• Sustainable cost advantages normally involve many parts of the company, not just one function or technology.
• Successful cost leaders multiply their cost advantages: the culture of low cost permeates the entire company, not just production.

The value chain

• Ultimately, all cost or price differences between rivals arise from the hundreds of activities that companies perform as they compete (managing a supply chain, operating a sales force, developing products, delivering them).
• The sequence of activities your company performs to design, produce, sell, deliver, and support its products is called the value chain.
• In turn, your value chain is part of a larger value system: the larger set of activities involved in creating value for the end user, including upstream and downstream.
• Competitive advantage is a difference in relative price or relative costs that arises because of differences in the activities being performed.
• The value chain is a powerful tool to disaggregate a company into its strategically relevant activities and focus on the sources of competitive advantage, i.e. the specific activities that result in higher prices or lower costs.

Key steps in value chain analysis

1. Lay out the industry value chain.
2. Compare your value chain to the industry’s.
3. Zero in on price drivers, those activities that have a high impact on differentiation. Do you or could you create superior value for your customers by performing activities in a distinctive way or by performing activities that competitors do not perform? Can you create that value without incurring commensurate costs? Buyer value can come from product design, choice of inputs, production process, selling experience, after-sales support.
4. Zero in on cost drivers, notably activities that represent a large or growing percentage of costs. Are there actual or potential differences between your cost structure and those of your rivals? The real “so what” of relative cost analysis comes when you dig deep enough into the numbers to uncover the actions you can take to improve them.
   

   

Do you really have a competitive advantage?

• How does the long-term profitability in each of your businesses stack up against other companies in the economy? Are the returns for your business better or worse? If better, something is working in your favor. If worse, then something is wrong.
• Now compare your performance to the average return in your industry over a full investment cycle (5-10 years).
• Next, keep digging to understand why the business is performing better (competitive advantage) or worse (strategic issue) than the industry average. Disaggregate your relative performance into its two components: relative price and relative cost.
• Dig further. On the price side, it may be possible to trace the overall price premium (or discount) to differences in particular product lines, in customers or geographic areas, or in list price versus discounts off list. On the cost side, it is often revealing to disaggregate the cost advantage (or disadvantage) into the part due to operating cost (income statement) and the part due to the utilization of capital (balance sheet).

Consequences of value chain thinking

The consequences of value chain thinking are the following:

1. You begin to see each activity not just as a cost, but as a step that has to add some increment of value to the finished product or service (i.e. matching the value chain to the customer’s definition of value).
2. It forces you to look beyond the boundaries of your own organization and its activities and to see that you are part of a larger value system involving other players.

What is strategy?

• Competitive advantage means you have created value for customers and you are able to capture value for yourself because the positioning you have chosen in your industry effectively shelters you from the profit-eroding impact of the five forces.

The five tests of a good strategy

• Every good strategy must pass 5 tests:
  1. A distinctive value proposition
  2. A tailored value chain
  3. Trade-offs different from rivals
  4. Fit across value chain
  5. Continuity over time.
• A unique value proposition and a tailored value chain are the core of a strategy.
• Trade-offs make differences in price and cost possible and sustainable.
• Fit is an amplifier, enhancing the price and cost differences.
• Continuity is the enabler: all the other elements take time to develop, and without continuity, firms are unlikely to get good at what they do.

Creating value: the core

• Strategic competition is the process of perceiving new positions that woo customers from established positions or draw new customers into the market.
• In practice, companies find new positions:
  1. By focusing externally on the customer and looking for new ways to segment customers or to serve unmet needs (distinctive value proposition);
  2. By focusing internally on operations and identifying their strengths, i.e. the unique set of activities the company performs (distinctive value chain).
• To establish a competitive advantage, a company must deliver its distinctive value proposition through a distinctive value chain.

A distinctive value proposition

• The value proposition answers three questions:
  1. Which customers.
  2. Which needs.
  3. What relative price.
• The choice of one of these legs can come first, and lead directly to the other two legs of the triangle.
• The first test of a strategy is whether your value proposition is different from your rivals: if you are trying to serve the same customers and meet the same needs and sell at the same relative price, then you don’t have a strategy.

Which customers

• Choosing the customers you will serve can be an important anchor in your positioning vis-à-vis the five forces.
• The following three examples show a segmentation based on different criteria (geography, demographics, psychographics), targeting a customer group overlooked or avoided by the industry:
  • Retailer Walmart started with isolated rural towns that other discounters were ignoring.
  • Auto insurer Progressive chose nonstandard drivers (limited alternatives, little bargaining power).
  • Wealth manager Edward Jones chose conservative investors who delegate financial decisions to a trusted advisor (less price sensitive, more loyal) rather than the conventional High Net Worth customer.
• While it is not essential to target overlooked customers, it is essential to find a unique way to serve your chosen segment profitably.

Which needs

• Value propositions based on needs appeal to a mix of customers who might defy traditional demographic segmentation.
• While Hertz and other rental car companies built their business around travelers, Enterprise Rent-A-Car, the most profitable one, focuses on home city rentals (e.g. customers whose car is stolen or being repaired) with reasonably priced, convenient, home-city rentals, often paid for by insurers. Zipcar further segmented home renters, focusing on people who choose not to own a car, but who occasionally need to use one, and offering them extreme convenience in vehicle pickup and drop-off, extreme flexibility in the rental period, clear, all-inclusive pricing that includes insurance and gas, and an intangible “cool” factor.

What relative price

• Some value propositions target customers who are overserved and hence overpriced by other offerings in the industry (e.g. Southwest Airlines).
• Others target customers who are underserved and hence underpriced by other offerings (e.g. NetJets).

A tailored value chain

• A distinctive value proposition will not translate into a meaningful strategy unless the value chain is tailored to the value proposition, and the company chooses to perform activities differently or to perform different activities from rivals.
  • While Hertz has office locations in airports, hotels, train stations, offers a full range of late models, and markets through consumer advertising, Enterprise has office locations in cheaper metropolitan areas, offers an older fleet of sensible cars, and markets through body shops and insurers.
  • Similarly, while full-service airline carriers use a hub-and-spoke system centered on major airports, offer meals, assigned seats, first and business class, coordinate with connecting flights, sell through web-based travel sites, and use several aircraft models, Southwest does none of the above, enabling a faster gate turnaround, leaner ground crews, longer flying hours per plane, lower maintenance costs, and lower sales commissions.
• Tailoring is possible only if there are limits, i.e. if you are not trying to be all things to all people.

Generic strategies

• Porter identified a set of generic strategies with a dominant theme:
  1. Focus
  2. Differentiation
  3. Cost leadership.
• Focus refers to the breadth and narrowness of the customers and needs served by the company.
• Differentiation allows a company to command a premium price.
• Cost leadership allows it to compete by offering a low relative price.
• Companies that try to be all things to all customers end up outflanked by cost leaders on one side and differentiators on the other side.
• While generic strategies identify the dominant theme, effective strategies integrate multiples themes in a unique way, making it possible to be differentiated, low cost, and focused at the same time, as Enterprise Rent-A-Car, without being “stuck in the middle”.

Trade-offs: the linchpin

Competitive advantage depends on making trade-offs

• Contrary to popular thinking, competitive advantage depends on making trade-offs.
• Managers mistakenly tend to believe that “more is always better” and that it is not possible to sustain a competitive advantage.
• But companies such as Southwest Airlines, IKEA, Walmart, Enterprise Rent-A-Car, BMW, McDonald’s, Apple and others attest that trade-offs can lead to persistent competitive advantages.

Trade offs arise for a number of reasons

1. Product features may be incompatible (IKEA’s stores are not suited for customers that want to make a quick “in and out” purchase, McDonald’s hamburgers are not satisfying for locavores who want healthy, farm-fresh ingredients).
2. The configuration that best delivers one kind of value cannot equally well deliver another (a plant designed to handle small lot sizes and custom products will be less efficient for large production runs or standard products).
3. There may be inconsistencies in image or reputation (when Sears acquired a broker and tried to sell investment products as well as power tools, customers could not reconcile the new image with the old).

False trade-offs arise when companies fall behind in operational effectiveness

• Quality is free when higher quality means eliminating defects and waste.
• Lexus was able to offer more luxury than Cadillac at a lower price because the latter had fallen behind the current state of best practice.
• Once companies achieve parity in execution, they face real trade-offs.
• When managers focus on execution, on making sure that they are “best practice” when it comes to generic activities, then eliminating trade-offs can be a good thing.
• When it comes to strategy, however, trade-offs are essential in making what you do unique.

Real trade-offs keep imitators at bay

• If you are successful and competitors aren’t asleep, they will try to copy what you do.
• But when there are trade-offs, copycats will pay an economic penalty.
• Straddling is the most common form of competitive imitation: the straddler tries to match the benefits of the successful competitor’s position, while maintaining its existing position.
• If you’re going to occupy two distinct positions in the same business, the only way to bypass the trade-offs is to create a separate organization with the freedom to choose its own, tailored value chain.
• Even when you do that, it is still a very hard act to pull off.
• Repositioning is another way a company can copy another: when its existing position is no longer viable, it may try to reposition itself by copying someone else’s strategy in its entirety, effectively running the same race as a rival who has a giant head start.

Choosing what not to do

• Deciding which needs to serve and which products to offer is key to developing a strategy.
• But it is just as important to decide which needs you will not serve, which products, features, or services you won’t offer, and to stick to those decisions.
• Building and sustaining competitive advantage means that you must be disciplined about saying no to a host of initiatives that would blur your uniqueness.
• Companies tend over time to add functions and features to their products (“the incremental cost of adding a feature is minimal”; “we need the revenue growth”; “we have to match what our rivals are offering”; “our customers are telling us this is what they want”; “we will lose customers”).
• This “feature creep” is a slippery slope that leads to competition to be the best.
• When you try to offer something for everyone, you tend to relax the trade-offs that underpin your competitive advantage, and are unlikely to do a good job of serving any customers and needs.
• The role of trade-offs in strategy is deliberately to make some customers unhappy.
• The notion that “the customer is always right” can lead to mediocre performance: some of those customers are not your customers, and you should send them packing,

Fit: the amplifier

What is fit and why does it matter?

• Fit has to do with how the activities in the value chain relate to one another, through value or cost.
• Good strategies depend on the connection among many things, on making interdependent choices.
• Fit amplifies the competitive advantage of a strategy by lowering costs or raising customer value (and price).
• Fit makes strategy more sustainable by raising barriers to imitation.

The three kinds of fit

There are three kinds of fit:

1. Basic consistency: each activity is aligned with the company’s value proposition and contributes incrementally to its dominant themes (when activities are inconsistent, they cancel each other out).
2. When activities complement or reinforce each other: this is real synergy, where the value of each activity is raised by the other.
3. Substitution: performing one activity makes it possible to eliminate another.

Activity map

An activity map can help identify ways to strengthen overall positioning, fit, and sustainability.

1. Start by identifying the core elements of the value proposition (e.g., for IKEA, distinctive design, low prices, immediate use).
2. Identify the activities that contribute most to customer value or that generate significant cost.
3. Place activities on a map and draw lines wherever there is fit.
4. For each activity, ask how it could be better linked to the overall strategy.
5. Can you find new ways in which activities can reinforce each other or where one activity can substitute for others?
6. Can you find new activities, or enhancements to what you already do, whose cost or effectiveness is improved by your existing activity system?
7. Are there services, features, or product varieties that you can offer (and rivals cannot) because of the other things that you already do?
   

   

Fit and core competence

• A common mistake in strategy is to choose the same core competences as everyone else in your industry.
• Fit means:
  1. That the whole matters more than any individual part.
  2. That many things together create value, not just a few things in isolation (e.g., one or two core competences).
  3. That the competitive value of individual activities—and the associated skills, competences, or resources—cannot be decoupled from the system or the strategy.
  4. That value comes not from “core competences” alone, but from how they are deployed in the company’s positioning.
• The logic of core competences has led many companies to pursue outsourcing without thinking through the strategic consequences. But once you appreciate the role of fit, you will stop and think much harder about outsourcing. Instead of trying to determine which activities are core, Porter asks a different question: Which activities are generic and which are tailored? Generic activities—those that cannot be meaningfully tailored to a company’s position—can be safely outsourced to more efficient external suppliers. However, outsourcing is risky for activities that are or could be tailored to strategy, especially those that are strongly complementary with others.

Fit makes strategy more sustainable

• While tailoring and trade-offs make it hard for existing rivals to copy a successful strategy, either by straddling or repositioning, fit explains how competitive advantage can be sustained against new entrants.
• To get the benefit of imitation, you now have to copy a whole nest of interdependent activities.
• Porter argues that fit deters imitation in a number of ways:
  1. Rivals will have a hard time figuring out what they have to match.
  2. Even if they can identify relevant interconnections, they’ll have a hard time replicating them all as fit is organizationally challenging.
  3. Firms with strong fit are typically superior in both strategy and execution, and thus less likely to attract imitators in the first place.
  4. Fit locks out imitators by creating a chain that is as strong as its strongest link.

Continuity: the enabler

The final test of strategy is continuity over time

• A unique value proposition and a tailored value chain are the core of a strategy.
• Trade-offs make differences in price and cost possible and sustainable.
• Fit is an amplifier, enhancing the price and cost differences.
• Continuity is the enabler: all the other elements take time to develop, and without continuity, firms are unlikely to develop competitive advantage.
• It usually takes years, not months, to successfully implement a new strategy.

Strategy is a stew, it takes time for the flavors and textures to develop

• It is a mistake to think that a strategy should be fully defined in its entirety before the fact (there are too many variables and too much uncertainty to anticipate everything).
• Great companies have spent decades creating complex business systems elegantly configured to produce a certain kind of value in a specific industry context.

Strategy begins with a few essential choices

• There must be a stable core to begin with, or at least a grounded hypothesis about how the company is going to create and capture value.
• Often, strategies begin with two or three essential choices.
• Over time, as the strategy becomes clearer, additional choices complement and extend the original ones.

Organizations are complex and require time to become really proficient

Continuity of direction:

1. Reinforces a company’s identity (a good strategy, consistently maintained over time through repeated interactions with customers, is what gives power to a brand).
2. Helps suppliers, channels, and other third parties contribute to competitive advantage (continuity of strategy allows them to better they understand the company’s goals and methods, and attracts employees who fit the strategy.
3. Fosters improvements and fit across activities, and the building of unique capabilities and skills tailored to strategy (e.g. customized employee screening and training programs).
4. Increases the odds that people throughout the organization will understand the company’s strategy and how they can contribute to it (the more they “get it,” the more likely they are to make decisions that reinforce and extend the strategy).

Continuity of strategy does not mean standing still

As long as there is stability in the core value proposition, there can, and should, be enormous innovation in how it’s delivered:

1. You must stay on the frontier of operational effectiveness (continuously assimilate best practices that do not conflict with your strategy or the trade-offs essential to it.
2. You must change whenever there are ways to extend your value proposition or better ways to deliver it.

Strategy does not require a detailed prediction of the future

• You only need a very broad sense of which customers and needs are going to be relatively robust five or ten years from now.
• Strategy is implicitly a bet that the chosen customers or needs—and the essential trade-offs for meeting them at the right price—will be enduring.

There are times when a strategy must be changed

Good strategies have staying power, but there are clearly times when a strategy must be changed:

1. As customer needs change, a company’s core value proposition may simply become obsolete.
2. Innovation can invalidate the essential trade-offs on which a strategy relies.
3. A technological or managerial breakthrough can completely trump a company’s existing value proposition.

Practical implications

• Vying to be the best is an intuitive but self-destructive approach to competition.
• There is no honor in size or growth if those are profitless. Competition is about profits, not market share.
• Competitive advantage is not about beating rivals; it is about creating unique value for customers.
• If you have a competitive advantage, it will show up on your P&L.
• A distinctive value proposition is essential for strategy. But strategy is more than marketing. If your value proposition doesn’t require a specifically tailored value chain to deliver it, it will have no strategic relevance.
• Don’t feel you have to “delight” every possible customer out there. The sign of a good strategy is that it deliberately makes some customers unhappy.
• No strategy is meaningful unless it makes clear what the organization will not do. Making trade-offs is the linchpin that makes competitive advantage possible and sustainable.
• Don’t overestimate or underestimate the importance of good execution. It is unlikely to be a source of a sustainable advantage, but without it even the most brilliant strategy will fail to produce superior performance.
• Good strategies depend on many choices, not one, and on the connections among them. A core competence alone will rarely produce a sustainable competitive advantage.
• Flexibility in the face of uncertainty may sound like a good idea, but it means that your organization will never stand for anything or become good at anything. Too much change can be just as disastrous for strategy as too little.
• Committing to a strategy does not require heroic predictions about the future. Making that commitment actually improves your ability to innovate and to adapt to turbulence.

Common mistakes

Competing to be the best

• The granddaddy of all mistakes is competing to be the best.
• Going down the same path as everybody else and thinking that somehow you can achieve better results.

Confusing marketing with strategy

• Another common mistake is confusing marketing with strategy.
• It is natural for strategy to arise from a focus on customers and their needs.
• So in many companies, strategy is built around the value proposition, which is the demand side of the equation.
• But a robust strategy requires a tailored value chain—it is about the supply side as well, the unique configuration of activities that delivers value.

Overestimating strengths

• Another mistake is to overestimate strengths.
• There is an inward-looking bias in many organizations.
• You might perceive customer service as a strong area, so that becomes the “strength” on which you attempt to build a strategy.
• But a real strength for strategy purposes has to be something the company can do better than its rivals.
• And “better” because you are performing different activities than they perform, because you’ve chosen a different configuration than they have.

Defining the business or geographic scope wrong

• Another common mistake is getting the definition of the business wrong, or getting the geographic scope wrong.
• Following the works of Theodore Levitt, there has been a tendency to define industries broadly:
  • e.g., railroads as being in the transportation business: the problem is that railroads are clearly a distinct industry than trucks and airfreight, with distinct economics and a separate value chain.
• Similarly, there has been a tendency to define industries as global when they are national or encompass only groups of neighboring countries, leading companies to internationalize without understanding the true economics of their business.
• The value chain is the principal tool to delineate the geographic boundaries of competition:
  • In a local business, every local area will require a complete and largely separate value chain,.
  • A global industry is one where important activities in the value chain can be shared across all countries.

Not having a strategy

• The worst mistake—and the most common one—is not having a strategy at all.
• There are many barriers that distract, deter, and divert managers from making clear strategic choices:
  1. Internal environment: some of the most significant barriers come from the many hidden biases embedded in internal systems, organizational structures, and decision-making processes. It is often hard, for example, to get the kind of cost information you need to think strategically. Or the company’s incentive system rewards the wrong things. Or human nature makes it really hard to make trade-offs, or to stick with them.
  2. External environment: these range from “industry experts” (who help you benchmark yourself against everyone else in the industry, or push the “next big thing”, such as the notion that you’re supposed to delight and retain every single customer) to financial analysts (who want every company to show progress on the same metrics and look like the current market favorite) and regulators.

Growth: opportunities and pitfalls

The pressure to grow is among the greatest threats to strategy

Companies too often believe that any growth is good, and have a tendency to overshoot, adding product lines, market segments, or geographies that blur uniqueness, create compromises, reduce fit, and undermine competitive advantage.

Never copy

If your competitor has a good idea, learn from it, think about what that innovation accomplishes, and how the idea could be adapted and modified to reinforce your strategy.

Deepen your strategic position, don’t broaden it

The first place to look for growth is to deepen your penetration of your core target of customers, which involves making the company’s activities more distinctive, strengthening fit, and communicating the strategy better to those customers who clearly benefit from what you uniquely do. Gaining 10% share in another segment where you have no advantage will often damage your profitability.

Expand geographically in a focused way

When going to a foreign market:

1. Don’t try to compete like existing local companies.
2. Find those customers who are in your sweet spot.
3. Have direct contact with the customer (it is hard to work through someone else’s distribution channels).
4. Be careful when making and integrating acquisitions (“this is how things are done in this country”).

Alternative

If none of these approaches to growth is feasible:

• Make a good ROIC.
• Pay good dividends.
• Return capital.
• Enjoy creating value and wealth.

Strategy and innovation

• Industry still matters. The relative profitability differences across industries are remarkably durable. Even where industry boundaries change, every industry has a distinct structure, and its peculiar configuration of the five forces drives the nature of competition.
• Not all technologies are disruptive. A disruptive technology is one that invalidates value chain and product configurations in ways that allow one company to leap ahead of another and/or make it hard for incumbents to match or respond because of the existing assets they have. To tell whether you are dealing with a disruptive technology, ask: (1) “To what extent does it invalidate important traditional advantages?” and (2) “To what extent can incumbents embrace the technology without major negative consequences for their business?”.
• Disruption can come from below or from above. Disruption from below is an example of a focus strategy: if you focus on customers who don’t need all the special bells and whistles, you can establish a beachhead with a simpler and less costly technology. But the threat can also come from above, with an advanced technology or a richer approach that can be simplified or streamlined to meet less sophisticated needs at much lower cost.
• A business model is about viability, while a strategy is about superior performance. If you are starting a business, the business model concept helps you to focus on the most basic question of all: “How are we going to make money? Where will our revenue come from? What will our costs look like? How can this business be profitable?”. Strategy goes beyond the basic viability question (“Can we make money?”) and asks “How can we make more money than our rivals, and how can we sustain that advantage over time?”. A business model highlights the relationship between your revenues and your costs, while strategy looks at how your revenues and costs stack up against your rivals, and links those to the activities in your value chain, and ultimately your income statement and balance sheet.
• Strategy is relevant at any point in a company’s trajectory. Even in new markets, where there is a lot of experimentation and forecasting, the five forces exercise is the same, and if you are creating something that is truly valuable, do not kid yourself that no one will follow you.

Special cases

Unattractive industries

• The structure of any industry is heavily influenced by some underlying economics:
  • e.g., the airline industry suffers from an unusual combination of low entry barriers, high exit barriers (capacity does not leave the market), high fixed costs and low variable costs, leading to an intense pressure to fill planes.
• But some aspects of industry structure reflect choices made by industry leaders:
  • e.g., yield management, which has been a disaster as it created permanent price competition.
• Such choices can be modified by leadership, with an important caveat to keep in mind:
  • When you are going for competitive advantage, you are trying to be unique.
  • When you are trying to change the industry structure, you want everyone else to follow you.

Companies in developing countries

• They typically have lower factor costs (e.g. labor) that might let them compete with foreign rivals even if their products are not distinctive.
• But factor cost advantages diminish over time, so companies in developing countries will eventually have to close the operational efficiency gap (deficits in workforce skill levels, technology, management capabilities) and begin to develop real strategies (unique position).
• They also often tend to be too domestic and too diversified.

Nonprofits

• Nonprofits should have a clear handle on what they are trying to do.
• Then all the other strategy principles apply:
  • What customer are you serving?
  • What’s the unique value you will deliver?
  • What needs will you meet?
  • How is your value chain tailored to best serve those needs?
  • Are you making trade-offs with alternative approaches?
  • Do you know what your organization will not do?

Strategic planning and leadership

1. You need to bring together the whole management team, and they need to do the plan together and develop the implications for action.
2. Planning should be done every year or two, with quarterly reviews.
3. Communicating the strategy (“What do we stand for as a company? What makes us distinctive? How are we unique?”) is really important as the purpose of strategy is to align the behavior of everyone in the organization and help them make good choices when they are on their own: Strategy should also be communicated to your customers, your suppliers, your channels, and the capital markets.
4. If some people do not accept the strategy, they cannot have an ongoing role. Letting dissenters hang on results in negative energy, confusion, and waste of time.