Understanding Michael Porter

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What is Competition

Competition the Right Mind-Set

Only by being unique can an organization achieve sustained, superior performance

How you think about competition will define the choices you make about how you are going to compete.
This can really apply to many fields, product, personality, business etc. For instance, my goal to differentiate in the job market is to combine knowledge of enterprise data tools with sales knowledge + knowledge + business

Competition focuses more on meeting customer needs than on demolishing rivals.

You don't want to be the best, you want to be only

Being the best doesn't really exist. It sets itself an impossible goal.

If all rivals pursue the "one best way" to compete, they will find themselves on a collision course (Prisoner's Dilemma)

For Porter, strategic competition means choosing a path different from that of others. Instead of competing to be the best, companies can—and should—compete to be unique.

Value is ultimately defined by customers.

Customers will pay more (or less) depending on how they perceive the value that’s offered to them.

Competing to be unique is unlike warfare in that one company’s success does not require its rivals to fail. It is unlike competition in sports because every company can chose to invent its own game. A better analogy than war or sports might be the performing arts. There can be many good singers or actors—each outstanding and successful in a distinctive way. Each finds and creates an audience. The more good performers there are, the more audiences grow and the arts flourish. This kind of value creation is the essence of positive-sum competition.

Competing to be the best feeds on imitation. Competing to be unique thrives on innovation.

The Five Forces: Competing for Profits

The framework to gain insight about your industry's performance and your own

The point of competition is to earn profits

Porter’s five forces tells you immediately how the industry “works,” how it creates and shares value. It explains the industry’s profitability.

5 Truths of Every Industry
First, as different from one another as industries might appear on the surface, the same forces are at work under the skin.
Second, industry structure determines profitability—not, as many people think, whether the industry is high growth or low, high tech or low, regulated or not, manufacturing or service.
Third, industry structure is surprisingly sticky. Despite the prevailing sense that business changes with incredible rapidity, Porter discovered that industry structure—once an industry passes beyond its emerging, prestructure phase—tends to be quite stable over time. New products come and go. New technologies come and go. Things change all the time. But structural change—and therefore change in the average profitability of an industry—usually takes a long time.

For any organization trying to assess or formulate strategy, the five forces framework is the place to start.

The five forces framework zeroes in on the competition you face and gives you the baseline for measuring superior performance.

Before you can make sense of your own performance (current and potential), you need insight into the industry’s fundamental economics.

Five forces analysis answers the key question, What’s going on out there in your industry?

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.
Suppliers
If you have powerful suppliers, they will use their negotiating leverage to charge higher prices or to insist on more favorable terms. In either case, industry profitability will be lower because suppliers will capture more of the value for themselves.
When you analyze the power of suppliers, be sure to include all of the purchased inputs that go into a product or service, including labor (i.e., your employees). The bargaining power of strong labor unions has been a perennial drag on the airline industry.

Assessing Supplier and Buyer Power
They are large and concentrated relative to a fragmented industry
The industry needs them more than they need the industry. In some cases, there may be no alternative suppliers, at least in the short term. Doctors and airline pilots, to cite two examples, have historically exercised tremendous bargaining power because their skills have been both essential and in short supply.
Switching costs work in their favor. Switching costs work in the buyer’s favor when the buyer can easily drop one vendor for another.
Differentiation works in their favor. When buyers see little differentiation in the industry’s products, they have the power to pit one vendor against another.
They can credibly threaten to vertically integrate into producing the industry’s product itself.

Substitutes
Substitutes—products or services that meet the same basic need as the industry’s product in a different way—put a cap on industry profitability.
Precisely because substitutes are not direct rivals, they often come from unexpected places. This makes substitutes difficult to anticipate or even to see once they appear.

New Entrants
Entry barriers protect an industry from newcomers who would add new capacity and seek to gain market share. The threat of entry dampens profitability in two ways. It caps prices, because higher industry prices would only make entry more attractive for newcomers. At the same time, incumbents typically have to spend more to satisfy their customers.

Rivalry
When rivalry among the current competitors is more intense, profitability will be lower. Incumbents will compete away the value they create by passing it on to buyers in lower prices or dissipating it in higher costs of competing. Rivalry can take a variety of forms: price competition, advertising, new product introductions, and increased customer service.

Memorizing the five forces won’t make you a better business thinker; it will only help you to sound like one. It matters that you grasp the deeper point: there are a limited number of structural forces at work in every industry that systematically impact profitability in a predictable direction.

Competitive Advantage

Competitive advantage is fundamentally about creating value, and doing so differently from rivals. How your value chain will be different and your P&L better than industry average

For Porter, competitive advantage is not about trouncing rivals, it’s about creating superior value.

The financial measure that best captures this idea is return on invested capital (ROIC).

Only if a company earns a good return can it satisfy customers in a sustainable way. Only if it uses resources effectively can it deal with rivals in a sustainable way.

Value Chain Analysis

Value Chain
Research and Development
Supply Chain Management
Operations
Marketing and Sales
Post-Sales Service

1. Start by laying out the industry value chain. Every established industry has one or more dominant approaches. These reflect the scope and sequence of activities that most of the companies in that industry perform
How far upstream do the industry’s activities extend? Does the industry do basic research? Does it design and develop its products? Does it manufacture? What key inputs does it rely on? Where do they come from? How does the typical player in the industry market, sell, distribute, deliver? Is financing or after-sales service a part of the value the industry creates for customers?
2.Next, compare your value chain to the industry’s.
3.  Zero in on price drivers, those activities that have a high current or potential 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 don’t perform? Can you create that value without incurring commensurate costs?
4. Zero in on cost drivers, paying special attention to activities that represent a large or growing percentage of costs. Your relative cost position (RCP) is built up from the cumulative cost of performing all the activities in the value chain. Are there actual or potential differences between your cost structure and those of your rivals?

Consider the enormous consequences of value chain thinking.
The first is that 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.
A second major consequence of value chain thinking is that 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.

The Economic Fundamentals of Competitive Advantage

The goal of strategy is to earn superior returns on the resources you deploy, and that is best measured by return on invested capital.

Competitive advantage is not about beating rivals; it’s about creating superior value and about driving a wider wedge than rivals between buyer value and cost.

Competitive advantage means you will be able to sustain higher relative prices or lower relative costs, or both, than your rivals in an industry. If you have a competitive advantage, it will show up on your P&L.

Differences in relative prices and relative costs can ultimately be traced to the activities that companies perform.

A company’s value chain is the collection of all its value-creating and cost-generating activities. The activities, and the overall value chain in which activities are embedded, are the basic units of competitive advantage.

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 value chain is a powerful tool for disaggregating a company into its strategically relevant activities in order to focus on the sources of competitive advantage, that is, the specific activities that result in higher prices or lower costs

What is Strategy

Strategy - “a good competitive strategy that will result in sustainably superior performance.”

Strategy explains how an organization, faced with competition, will achieve superior performance.

Creating Value: The Core

Trade-offs: The Linchpin

Fit: The Amplifier

Continuity: The Enabler

A Short List of 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’s 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’s 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.

Reflecting on my experience, however, I’d have to say that the worst mistake—and the most common one—is not having a strategy at all. Most executives think they have a strategy when they really don’t, at least not a strategy that meets any kind of rigorous, economically grounded definition.

I used to think that most strategy problems arose from limited or faulty data, or poor analysis of the industry and competitors. To say it differently, I thought the problem was a failure to understand competition. This surely does happen. But the more I have worked in this field, the more I have come to appreciate the more subtle and more pervasive obstacles to clear strategic thinking and how challenging it is for companies to maintain their strategies over time.

There are so many barriers that distract, deter, and divert managers from making clear strategic choices. Some of the most significant barriers come from the many hidden biases embedded in internal systems, organizational structures, and decision-making processes. It’s 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. The need for trade-offs is a huge barrier. Most managers hate to make trade-offs; they hate to accept limits. They’d almost always rather try to serve more customers, offer more features. They can’t resist believing that this will lead to more growth and more profit.

When you’ve got your strategist’s hat on, you want to decide which customers and which needs you want to meet. As to the other customers and the other needs, well, you just have to get over the fact that you will disappoint them, because that’s actually a good thing.

Capital markets have become toxic for strategy. The single-minded pursuit of shareholder value . . . has been enormously destructive for strategy and value creation.

These are just some of the obstacles. Cumulatively, they add up. Having a strategy in the first place is hard. Maintaining a strategy is even harder.

My advice (To grow a business without undermining strategy) is to concentrate on deepening and extending a strategic position rather than broadening and ultimately compromising it. Here are some thoughts about how to grow profitably without destroying your strategy. First, never copy. Companies always are confronted with opportunities for new products, new services, or moving into adjacent customer groups. How should you think about that? If your competitor has a good idea, learn from it, think about what that innovation accomplishes, but don’t just copy it. Figure out how the idea could be adapted and modified in order to reinforce your strategy. Is it relevant to the needs you’re trying to serve? Could it be used to reinforce what makes you unique? You don’t have to jump on every trend. But if the trend is relevant, tailor it to your strategy.

Second, deepen your strategic position, don’t broaden it. A company can usually grow faster—and far more profitably—by better penetrating needs and customers where it is distinctive than by slugging it out in potentially higher growth arenas in which the company lacks uniqueness. So the first place to look for growth is to deepen your penetration of your core target of customers. The common mistake is to settle for 50 percent of your target segment when 80 percent is achievable. You can shoot for true leadership when the customer target is properly defined not as the whole industry, but as the set of customers and needs that your strategy serves best.

Going deeper allows you to leverage all your advantages and improve profitability. Deepening a strategic position in this way 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 percent share in another segment where you have no advantage will often damage your profitability.

A disruptive technology is not any new technology. Many new technologies are not disruptive. Nor is it any big technological leap, because many big leaps are not disruptive. A disruptive technology is one that invalidates value chain configurations 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. So a disruptive technology is one that would invalidate important competitive advantages.

The Internet offers a classic case. It was disruptive where the mechanism for delivering information was fundamental to the product or service, where the business, in essence, was the delivery mechanism. Travel agents, for example, or the recorded music business. But in other cases, the Internet wasn’t disruptive because it was simply one more channel for communicating with customers or suppliers. In those cases, established companies with the best product sets and brands were simply able to incorporate the new technology. It wasn’t incompatible or inconsistent with anything they were doing.

Two questions will tell you whether you’re dealing with a disruptive technology or not. First, to what extent does it invalidate important traditional advantages? Second, to what extent can incumbents embrace the technology without major negative consequences for their business? If you stop and ask those questions, you’ll see that true disruptions are not so common. If you look over a decade, for example, at the hundreds of industries that make up the economy, I would guess that less than 5 to 10 percent would be affected by a disruptive technology.

If you focus on the customers who don’t need all the special bells and whistles, you can establish a beachhead. A focuser with a disruptive technology can enter your industry and ultimately grow to occupy a major position. This is the Southwest Airlines story.

Strategy is relevant for any organization at any point in its trajectory. How to develop and sustain a competitive advantage is the core question that every organization has to answer if it’s to be successful and to prosper.

Strategy is about the whole enterprise, not the individual pieces. That’s a foundational principle of good strategy. There’s no such thing as a good marketing strategy. There’s only a good marketing strategy in the context of the overall strategy. The danger with sending people off to do their own functional plans is that you’ll end up with a series of unconnected “best practices,” not a coherent strategy. That’s why a strategic plan needs to involve the whole management team working together to think about the industry, the competitors, the opportunities, the value chain, and then ultimately make some choices about positioning and direction. Then, the team needs to develop the implications for action. I believe it’s beneficial to have a formal strategic planning process because otherwise the day-to-day pressures of the business drive out strategy. There needs to be a process once every year or two, and then quarterly reviews. But you can’t let it be simply about budgeting and making guesses about next year’s growth rate. Planning needs to support thinking rather than drive it out.

How do you communicate it? Well, you’ve got to find a concise and memorable way to explain your strategy. Really good leaders crystallize the value proposition into something relatively simple. And then they help individual units in the organization translate what that means for every activity.

Good leaders are strategy professors, in the sense that they’re teaching strategy all the time. They’re giving lots of little talks about strategy. They start every meeting with the twenty-fifth repetition of the essence of the value proposition. Then it goes on to whatever the meeting is about.

What do we stand for as a company? What makes us distinctive? How are we unique? And it goes on from there. You’re constantly repeating and you’re encouraging your direct reports to also give the same speech to their organizations. It’s important, if you’re the general manager, to sit in on some of those meetings where your direct reports are trying to explain the strategy, and listen to see how they do, just to make sure that people really understand it.

Competitive Advantage - Porter’s definition is tightly linked to the economics of competition: you have competitive advantage if your profitability is sustainably higher than that of your rivals. Then you can dig further to understand whether that advantage comes from higher prices, lower costs, or some combination of both.

Introduction
“The essence of strategy,” Porter often says, “is choosing what not to do.”
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if there were no competition, there would be no need for strategy.
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Competition: The Right Mind-Set. Misconceptions of what competition is and how it works give rise to mistakes in strategy. The most common error of all is that competitive success comes from “being the best.” This mind-set is highly intuitive. It is also self-destructive, leading to a zero-sum race to the bottom. Only by competing to be unique can an organization achieve sustained, superior performance.
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Instead, use the framework to gain insight about your industry’s performance and your own.
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Properly understood, competitive advantage allows you to follow the precise link between the value you create, how you create it (your value chain), and how you perform (your P& L).
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For Porter, it’s fundamentally about creating value, and about doing so differently from rivals. In this way, competitive advantage is about how your value chain will be different and your P& L better than the industry average.
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A distinctive value proposition will translate into a meaningful strategy only if the best set of activities to deliver it is different from the activities performed by rivals. Competitive advantage lies in the activities, in choosing to perform activities differently or to perform different activities from rivals. A tailored value chain is strategy’s second test.
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Competitive advantage lies in the activities, in choosing to perform activities differently or to perform different activities from rivals. A tailored value chain is strategy’s second test.
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The third test of strategy may well be the hardest. Making trade-offs means accepting limits—saying no to some customers, for example, so that you can better serve others.
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Because a successful strategy will attract imitators, choices that are difficult to copy are essential.
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Trade-offs are the economic linchpins of strategy for two reasons. First, they are an important source of differences in prices and costs among rivals. Second, they make it difficult for rivals to copy what you do without compromising their own strategies.
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A common piece of advice for managers has been to focus on their core activities and to outsource the rest. Fit challenges that bit of conventional wisdom.
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Competition is dynamic. Everyone can name once-proud companies brought low by their failure to change.
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It takes time to develop real competitive advantage, to understand the value you create, to achieve tailoring, trade-offs, and fit. If you grasp the role of continuity in strategy, it will change your thinking about change itself. Paradoxically, continuity of strategy improves an organization’s ability to adapt and to innovate.
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Part One: What Is Competition?
The key to competitive success—for businesses and nonprofits alike—lies in an organization’s ability to create unique value. Porter’s prescription: aim to be unique, not best. Creating value, not beating rivals, is at the heart of competition.
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Where does superior performance come from? Porter’s answer can be divided into two parts. The first part is attributable to the structure of the industry in which competition takes place.
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The second part is attributable to the company’s relative position within its industry. Strategic positioning reflects choices a company makes about the kind of value it will create and how that value will be created.
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1. Competition: The Right Mind-Set
the core question, performance in the face of competition. What value will your organization create? And how will you capture some of that value for yourself? That, Michael Porter tells us, is strategy’s job. Strategy explains how an organization, faced with competition, will achieve superior performance.
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Porter tells us, one of the reasons so many companies fail to develop good strategies is that the people running them operate with fundamental misconceptions about what competition is and how it works.
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How you think about competition will define the choices you make about how you are going to compete.
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Competition focuses more on meeting customer needs than on demolishing rivals. Just look around. Because there are so many needs to serve, there are many ways to win.
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Rather than enter a particular race with a particular rival, as Porter would put it, companies can choose to create their own event.
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The best sales encounter for one customer is not the best for another. There is no best art museum, no one best way to promote environmental sustainability.
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But that’s not all. If rivals all pursue the “one best way” to compete, they will find themselves on a collision course.
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As is often the case, one company’s attempt to be “the best” ended up raising the bar for everyone.
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In practice, most industries exhibit multiple scale curves, each based on serving different needs.
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For Porter, strategic competition means choosing a path different from that of others. Instead of competing to be the best, companies can—and should—compete to be unique.
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Competition to be unique reflects a different mind-set and a different way of thinking about the nature of competition. Here, companies pursue distinctive ways of competing aimed at serving different sets of needs and customers. The focus, in other words, is on creating superior value for the chosen customers, not on imitating and matching rivals.
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Customers will pay more (or less) depending on how they perceive the value that’s offered to them.
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Competing to be the best feeds on imitation. Competing to be unique thrives on innovation.
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There is nothing foreordained or predetermined about the path that industries take to zero-sum or to positive-sum competition. There is nothing inherent in the industry—whether it is high tech or low, whether it is service or manufacturing—that will determine its fate. Some industries do face tougher economic challenges than others, but the path that industries take is also the result of choices—strategic choices—that managers make about how to compete. Bad choices unleash a race to the bottom. Good choices promote healthy competition, innovation, and growth.
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Competition to be unique, Porter’s work teaches, can make life better across almost all fields of human endeavor—but only if managers understand that their choices will influence the kind of competition that prevails in their industry.
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Instead, competition is multidimensional, and strategy is about making choices along many dimensions, not just one. No single prescription about which choices to make is valid for every company in every industry.
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there are underlying principles that can be used to analyze any competitive situation and to determine which choices make sense.
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Why are some companies more profitable than others? That’s the big question we’ll be working on. The answer has two parts. First, companies benefit from (or are hurt by) the structure of their industry. Second, a company’s relative position within its industry can account for even more of the difference.
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2. The Five Forces: Competing for Profits
But this way of thinking about competition is too narrow. The real point of competition is not to beat your rivals. It’s not about winning a sale. The point is to earn profits. Competing for profits is more complex. It’s a struggle involving multiple players, not just rivals, over who will capture the value an industry creates. It’s true, of course, that companies compete for profits with their rivals. But they are also engaged in a struggle for profits with their customers, who would always be happier to pay less and get more.
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The real point of competition is not to beat your rivals. It’s to earn profits. These five forces—the intensity of rivalry among existing competitors, the bargaining power of buyers (the industry’s customers), the bargaining power of suppliers, the threat of substitutes, and the threat of new entrants—determine the industry’s structure, an important concept that may sound academic but is not
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If you look at a building, any building—a house, a church, a warehouse—its structure immediately gives you important information about its use, about how the building “works,” how it creates shelter by enclosing space. The structure is determined by elements common to all buildings: the foundation, the walls, the roof. Similarly, you get important information about an industry by looking at its structure. The particular configuration of Porter’s five forces tells you immediately how the industry “works,” how it creates and shares value. It explains the industry’s profitability.
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First, as different from one another as industries might appear on the surface, the same forces are at work under the skin.
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Second, industry structure determines profitability—not, as many people think, whether the industry is high growth or low, high tech or low, regulated or not, manufacturing or service.
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Third, industry structure is surprisingly sticky. Despite the prevailing sense that business changes with incredible rapidity, Porter discovered that industry structure—once an industry passes beyond its emerging, prestructure phase—tends to be quite stable over time. New products come and go. New technologies come and go. Things change all the time. But structural change—and therefore change in the average profitability of an industry—usually takes a long time.
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For any organization trying to assess or formulate strategy, the five forces framework is the place to start.
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The five forces framework zeroes in on the competition you face and gives you the baseline for measuring superior performance.
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Before you can make sense of your own performance (current and potential), you need insight into the industry’s fundamental economics.
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Industry structure is an exponentially more powerful and objective tool for understanding the dynamics of competition. It is systematic, reducing the odds that you will miss something important. It is (or should be) built on facts and analysis, not just a listing of bullet points. Therefore it is less likely to result in a rehash of old agendas and more likely to teach you something new. It tackles the economic fundamentals of competition in a way that highlights how external forces constrain or create strategic opportunities for your company.
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Here’s how each force works.
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But let me stress that one of the great clarifying disciplines of Porter’s approach is to force you to think clearly about your industry’s structure. Start there. Then you can focus on your own and rivals’ relative positions within the industry. Buyers If you have powerful buyers (that is, customers), they will use their clout to force prices down. They may also demand that you put more value into the product or service.
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Both industrial customers and consumers tend to be more price sensitive when what they’re buying is Undifferentiated Expensive relative to their other costs or income Inconsequential to their own performance
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Suppliers If you have powerful suppliers, they will use their negotiating leverage to charge higher prices or to insist on more favorable terms.
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When you analyze the power of suppliers, be sure to include all of the purchased inputs that go into a product or service, including labor (i.e., your employees). The bargaining power of strong labor unions has been a perennial drag on the airline industry.
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Both suppliers and buyers tend to be powerful if: They are large and concentrated relative to a fragmented industry (think Goliath versus many Davids). What percentage of an industry’s purchases/ sales does a supplier/ buyer represent? Look at the data and map out how it is trending. How painful would it be to lose that supplier or that customer? Industries with high fixed costs (e.g., telecommunications equipment and offshore drilling) are especially vulnerable to large buyers. The industry needs them more than they need the industry. In some cases, there may be no alternative suppliers, at least in the short term. Doctors and airline pilots, to cite two examples, have historically exercised tremendous bargaining power because their skills have been both essential and in short supply. China produces 95 percent of the world’s supply of neodymium, a rare earth metal needed by Toyota and other automakers for electric motors. Neodymium prices quadrupled in just one year (2010), as the Chinese restricted supply. Toyota is working hard to develop a new motor that will end its dependence on rare earth metals. Switching costs work in their favor. This occurs for a supplier when an industry is tied to it, as for example, the PC industry has been to Microsoft, its dominant supplier of operating systems and software. Switching costs work in the buyer’s favor when the buyer can easily drop one vendor for another. The ease with which customers can switch from one airline to another on popular routes makes it hard for airlines to raise prices or cut service levels. Frequent flyer programs were intended to raise switching costs, but they have not been effective. Differentiation works in their favor. When buyers see little differentiation in the industry’s products, they have the power to pit one vendor against another. As the PC itself has become more of a commodity, buyer power has grown. But the PC industry’s suppliers (Microsoft and Intel) are highly differentiated. Makers of PCs are squeezed in the middle, caught between powerful suppliers and powerful buyers. They can credibly threaten to vertically integrate into producing the industry’s product itself. Producers of beer and soft drinks have used this tactic to keep a lid on the prices of beverage containers. Substitutes Substitutes—products or services that meet the same basic need as the industry’s product in a different way—put a cap on industry profitability.
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Substitutes place a ceiling on the prices incumbents can sustain without eroding sales.
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Precisely because substitutes are not direct rivals, they often come from unexpected places. This makes substitutes difficult to anticipate or even to see once they appear.
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How do you assess the threat of a substitute? Look to the economics, specifically to whether the substitute offers an attractive price–performance trade-off relative to the industry’s product.
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Substitutes gain ground when buyers face low switching costs,
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It caps prices, because higher industry prices would only make entry more attractive for newcomers. At the same time, incumbents typically have to spend more to satisfy their customers. This discourages new entrants by raising the hurdle they would have to clear in order to compete.
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How do you size up the threat of new entry? If you are a current player, what can you do to raise those barriers? If you are thinking of entering a new industry, can you overcome the barriers that stand in your way? There are a number of different kinds of entry barriers. Start with the following questions to help you identify and assess them. Does producing in larger volumes translate into lower unit costs? If there are economies of scale, at what volumes do they kick in? The numbers matter. Where do these economies come from: From spreading fixed costs over a larger volume? From using more efficient technologies that are scale dependent? From increased bargaining power over suppliers? It costs about a billion dollars to develop a new operating system for a PC, costs that are recovered in a matter of weeks if you have Microsoft’s scale. Will customers incur any switching costs in moving from one supplier to another? Switching from a Mac to a PC, or vice versa, will cost you many hours of setup and relearning. Because Apple has been the small player with low market share, it has had much more to gain from luring customers away from Microsoft. Therefore Apple has invested substantially in reducing those switching costs for PC users. Does the value to customers increase as more customers use a company’s product? (This is called a network effect.) As with economies of scale on the supply side, try to understand where the value comes from and what it’s worth. Sometimes the perceived stability or reputation of the company makes it a “safe” choice; sometimes value may come from the size of the network, as it does with Facebook. 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? Drug companies haven’t worried much about the threat of new entrants, and have therefore been free to raise prices, because the business has historically required such massive investment in R& D and marketing. Do incumbents have advantages independent of size that new entrants can’t access? Examples include proprietary technology, well-established brands, prime locations, and access to distribution channels. The latter, for example, can be a formidable entry barrier, especially if distribution channels are limited and the industry incumbents have them locked up. This can drive new entrants to create their own channels. For example, the upstart discount airlines had to sell tickets via the Internet because travel agents tended to favor the established airlines. Does government policy restrict or prevent new entrants? In my state of Massachusetts, licenses to sell wine are very hard to come by, severely limiting new entrants. Regulations, policies, patents, and subsidies can also work indirectly, by raising or lowering the other entry barriers. What kind of retaliation should a potential entrant expect should it choose to enter the industry? Is this industry known for making it tough for newcomers? Does the industry have the resources to compete aggressively? If industry growth is slow or if 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 more intense, profitability will be lower. Incumbents will compete away the value they create by passing it on to buyers in lower prices or dissipating it in higher costs of competing. Rivalry can take a variety of forms: price competition, advertising, new product introductions, and increased customer service. Drug companies, for example, have a history of intense competition in R& D and in marketing, but they have steered clear of price competition.
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How do you assess the intensity of rivalry? Porter notes that it is likely to be greatest if The industry is composed of many competitors or if competitors are roughly equal in size and power. Often an industry leader has the ability to enforce practices that help the whole industry. Slow growth provokes battles over market share. High exit barriers prevent companies from leaving the industry. This happens, for example, if companies have invested in specialized assets that can’t be sold. Excess capacity typically hurts an industry’s profitability. Rivals are irrationally committed to the business; that is, financial performance is not the overriding goal. For example, a state-owned enterprise might be propped up for reasons of national pride or because it provides jobs. Or, a corporation may feel its image requires a full product line. Price competition, Porter warns, is the most damaging form of rivalry. The more rivalry is based on price, the more you are engaged in competing to be the best. This is most likely when It is hard to tell one rival’s offerings from another (the problem of competitor convergence we saw in chapter 1) and buyers have low switching costs. This typically drives rivals to lower their prices to attract customers, a practice that has dominated airline competition for many years. Rivals have high fixed costs and low marginal costs, creating the pressure to drop prices because any new customer will “contribute to covering overhead.” Again, the essence of airline economics. Capacity must be added in large increments, disrupting the industry’s supply–demand balance and leading to price cutting to fill capacity. The product is perishable, an attribute that applies not only to fruit and fashion but also to a wide range of products and services that quickly become obsolete or lose their value. A hotel room, an airline seat, or a restaurant table that goes unfilled is “perishable.”
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The collective strength of the five forces matters because it affects prices, costs, and the investment required to compete. Industry structure determines how the economic value created by an industry is divided—how much is captured by companies in the industry versus customers, suppliers, distributors, substitutes, and potential new entrants. Industry structure can be linked directly to the income statements and balance sheets of every company in the industry. The insights gained from this kind of analysis should lead directly to decisions about where and how to compete. How can you use industry analysis? Consider two representative examples. First, does the industry offer the possibility of attractive returns?
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Typical Steps in Industry Analysis Define the relevant industry by both its product scope and geographic scope.
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Identify the players constituting each of the five forces and, where appropriate, segment them into groups. On what basis do these segments emerge? Assess the underlying drivers of each force. Which are strong? Which are weak? Why? The more rigorous your analysis, the more valuable your results. Step back and assess the overall industry structure. Which forces control profitability? Not all are equally important. Dig deeper into the most important forces in your industry. Are your results consistent with the industry’s level of profitability today and over the long term? Are the more profitable companies better positioned in relation to the five forces? Analyze recent and likely future changes for each force. How are they trending? Looking ahead, how might competitors or new entrants influence industry structure? How can you position yourself in relation to the five forces? Can you find a position where the forces are weakest? Can you exploit industry change? Can you reshape structure in your favor? Five forces analysis is used most often to determine the “attractiveness” of an industry, and this is certainly indispensible for companies and investors deciding whether to exit, enter, or invest in an industry.
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In other words, a good five forces analysis allows you to see through the complexity of competition, and it opens the way to a host of possible actions you can take to improve performance. As unattractive as the PC business is for most of its players, Apple appears to have found a way to make money. By designing its own operating system, Apple has never been subject to Microsoft’s supplier power. By creating distinctive products, it has limited buyer power. Apple loyalists would rather pay more than switch. A second representative question is, Can you position your company where the forces are weakest? Consider the strategy developed by heavy-truck maker Paccar. This is another industry with an uninviting structure: There are many big, powerful buyers who operate large fleets of trucks; they are price sensitive because trucks represent a large piece of their costs. Rivalry is based on price because (a) the industry is capital intensive, with cyclical downturns, and (b) most trucks are built to regulated standards and therefore look the same. On the supplier side, unions exercise considerable power, as do the large independent suppliers of engines and drive train components. Truck buyers face substitutes for their services (rail, for example), which puts an overall cap on truck prices.
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Paccar has developed a positioning within this difficult industry where the forces are the weakest. Its target customer is the individual owner-operator, the guy whose truck is his home away from home. This customer will pay more for the status conferred by Paccar’s Kenworth and Peterbilt brands and for the ability to add a slew of custom features such as a luxurious sleeper cabin or plush leather seats. Paccar’s made-to-order products come with a number of accompanying services geared to make the owner-operator more successful.
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Paccar doesn’t try to compete by being the “best” truck maker in the industry. If it did, it would go after the same customers with the same products. It would get caught up in the industry’s price competition, intensifying rivalry, which, in turn, would cause further deterioration in industry structure. The lesson here is relevant to many companies in many industries: by your own choices in how you compete, you can easily make a bad situation worse.
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“Strategy,” Porter writes, “can be viewed as building defenses against the competitive forces or finding a position in the industry where the forces are weakest.”
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Structure Is Dynamic As some or all of the forces shift over time, industry profitability will follow. Industry structure is dynamic, not static, a point that Porter has to repeat often because there has been a remarkably persistent misconception that industry structure and positioning are static, and therefore irrelevant in a fast-changing world.
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In any industry, there is always change. The better your grasp of industry structure, the more likely it is you will spot and exploit new strategic opportunities or moves that could reshape industry structure in your favor. The challenge is to discern the changes that matter. Change that is truly strategic affects the five forces.
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The real point of competition is earning profits, not taking business away from your rivals. Business competition is about the struggle for profits, the tug-of-war over who gets to capture the value an industry creates. Companies compete for profits with their direct rivals, but also with their customers, their suppliers, potential new entrants, and substitutes.
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Using five forces analysis simply to declare that an industry is attractive or unattractive misses its full power as a tool. Because industry structure can “explain” the income statements and balance sheets of every company in the industry, insights gained from it should lead directly to decisions about where and how to compete. Industry structure is dynamic, not static. Five forces analysis can help anticipate and exploit structural change.
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3. Competitive: Advantage: The Value Chain and Your P&L
This misses the mark in important ways. For Porter, competitive advantage is not about trouncing rivals, it’s about creating superior value.
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Performance, Porter argues, must be defined in terms that reflect the economic purpose every organization shares: to produce goods or services whose value exceeds the sum of the costs of all the inputs. In other words, organizations are supposed to use resources effectively. The financial measure that best captures this idea is return on invested capital (ROIC). ROIC weighs the profits a company generates versus all the funds invested in it, operating expenses and capital. Long-term ROIC tells you how well a company is using its resources.* It is also, Porter points out, the only measure that matches the multidimensional nature of competition: creating value for customers, dealing with rivals, and using resources productively. ROIC integrates all three dimensions. Only if a company earns a good return can it satisfy customers in a sustainable way. Only if it uses resources effectively can it deal with rivals in a sustainable way.
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Only if a company earns a good return can it satisfy customers in a sustainable way. Only if it uses resources effectively can it deal with rivals in a sustainable way.
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Growth is another widely embraced goal, along with its sister goal, market share. Like ROS, these fail to account for the capital required to compete in the industry. Too often companies pursue unprofitable growth that never leads to superior return on capital. As Porter notes wryly when he talks to managers, most companies could instantly achieve rapid growth simply by cutting their prices in half.
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Porter’s solution to this problem requires some courage: the only way to know if you are achieving the ultimate goal of creating economic value is to be brutally honest about the true profits you’ve earned and all the capital you’ve committed to the business. Strategy, then, must start not only with the right goal, but also with a commitment to measure performance accurately and honestly. That’s a tall order, not because it’s technically challenging, but because the overwhelming tendency in organizations is to make results look as good as you possibly can.
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In gauging competitive advantage, then, returns must be measured relative to other companies within the same industry, rivals who face a similar competitive environment or a similar configuration of the five forces. Performance is meaningfully measured only on a business-by-business basis because this is where competitive forces operate and competitive advantage is won or lost. Just to keep our terminology straight, for Porter strategy always means “competitive strategy” within a business.
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If you have a competitive advantage, then, your profitability will be sustainably higher than the industry average (see figure 3-1). You will be able to command a higher relative price or to operate at a lower relative cost, or both.
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If a company has a COMPETITIVE ADVANTAGE, it can sustain higher relative prices and/ or lower relative costs than its rivals in an industry. From here Porter takes us through a thought process that’s a lot like peeling an onion. First, disaggregate the overall profitability number into its two components, price and cost. This is done because the underlying causal factors, the drivers of price and cost, are so different, and the implications for action are different as well.
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A company can sustain a premium price only if it offers something that is both unique and valuable to its customers.
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Create more buyer value and you raise what economists call willingness to pay (WTP), the mechanism that makes it possible for a company to charge a higher price relative to rival offerings.
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A consumer’s WTP is more likely to have an emotional or intangible dimension, whether it is the trust engendered by an established brand or the status associated with owning the latest electronic gadget.
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The ability to command a higher price is the essence of differentiation, a term Porter uses in this somewhat idiosyncratic way.
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Porter is after something different. He is focused on tracking down the root causes of superior profitability. He is also trying to encourage more precise and rigorous thinking by underscoring the distinction between price effects and cost effects. For Porter, then, differentiation refers to the ability to charge a higher relative price. My advice here: Don’t get hung up on the language, as long as you don’t get sloppy about the underlying distinction. Remind yourself that the goal of strategy is superior profitability and that one of its two possible components is relative price—that is, you are able to charge more than your rivals charge. Relative Cost The second component of superior profitability is relative cost—that is, you manage somehow to produce at 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. Dell Inc.’ s low relative costs up through the early 2000s came from both sources. Vertically integrated rivals, such as Hewlett-Packard, designed and manufactured their own components, built computers to inventory, and then sold them through resellers. Dell sold direct, building computers to customer orders using outsourced components and a tightly managed supply chain. These competing approaches had very different cost and investment profiles. Dell’s model required little capital since the company did not design or make components, nor did it carry much inventory. In the late 1990s, Dell had a substantial advantage in days of inventory carried. Because component costs were then dropping so fast, buying components weeks later, as Dell effectively did, translated into lower relative costs per PC. And Dell’s customers actually paid for their PCs before Dell had to pay its suppliers. Most companies have to finance the working capital they need to run their business. Dell’s strategy resulted in negative working capital, which further enhanced Dell’s cost advantage.
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Ultimately, all cost or price differences between rivals arise from the hundreds of activities that companies perform as they compete.
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Activities are discrete economic functions or processes, such as managing a supply chain, operating a sales force, developing products, or delivering them to the customer. An activity is usually a mix of people, technology, fixed assets, sometimes working capital, and various types of information. Managers tend to think in terms of functional areas such as marketing or logistics because that is how their own expertise or organizational affiliation is defined. That’s too broad for strategy. To understand competitive advantage, it is critical to zoom in on activities, which are narrower than traditional functions.
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well. To think clearly about actions you can take as a manager to impact prices and costs, you need to get down to the activity level where “what the company is good at” gets embodied in specific activities the company performs. 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.
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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.
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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, regardless of who performs those activities.
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In thinking about your value chain, then, it’s important to see how your activities have points of connection with those of your suppliers, channels, and customers. The way they perform activities affects your cost or your price, and vice versa.
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1. Start by laying out the industry value chain. Every established industry has one or more dominant approaches. These reflect the scope and sequence of activities that most of the companies in that industry perform, and this is as true for nonprofits as for any business. The industry’s value chain is effectively its prevailing business model, the way it creates value (see figure 3-2). It is where most companies in the industry have chosen “to sit” in relation to the larger value system.
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Next, compare your value chain to the industry’s.
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3. Zero in on price drivers, those activities that have a high current or potential 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 don’t perform? Can you create that value without incurring commensurate costs? Buyer value can arise throughout the value chain. It can come from product design, for example, as it does for Whirlwind Wheelchair. It can come from choices in the inputs used or the production process itself, both of which are key to the success of In-N-Out Burger, a chain of over 230 hamburger restaurants that uses only the freshest ingredients and prepares its limited menu on-site. It can be created by the selling experience, as any visitor to an Apple Store will tell you. Or, it can arise from after-sales support activities.
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