A new book on strategy recently crossed my desk, and I have to say it is an excellent read. It’s called Understanding Michael Porter, by Joan Magretta (Harvard Business Review Press, 2011). Porter’s ideas and concepts are foundational to the subject of competitive strategy, and it is always good to revisit them and clear away much of the confusion and downright nonsense that has been built up around the subject of competitive strategy and its formulation.
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As Magretta notes in her book, while Porter’s ideas on competitive strategy have evolved over the years, he has remained true to a few basic and consistent principles—what he calls his frameworks. Furthermore, as a trained economist, Porter emphasizes that business strategy is, at its heart, the art and science of applied microeconomics.
A key thought of Porter is that good strategy flows out of three frameworks: First, that higher profitability results from either higher prices or lower costs; second, that industry competition is driven by five fundamental forces; and third, the firm is a collection of activities (its value chain). These frameworks provide a way of developing strategy that is grounded in economics and whose purpose is to help a firm create a competitive advantage.
The term “competitive advantage” is a loaded one. Too often, it simply means anything that a firm happens to be especially good at. However, that is not what Porter means by the term. For him, a competitive advantage means that a firm attains an advantage in either price or cost, relative to rivals. Competitive advantage has an economic definition and is linked directly to firm’s bottom line.
All too often, firms compete by trying to be the best. For such firms, gaining a competitive advantage is viewed as doing the same things as the competition, only better. Firms that view competition this way tend to develop self-limiting strategies that focus on doing the same things better, and not on doing different things that lead to an advantage in either relative price or costs.
The problem with competing to be the best is that, if all firms in an industry are employing that philosophy, it leads to a convergence where no one wins. If all firms in an industry are trying to serve the same customers, with the same products and services, with the same value chains and the same degree of excellence, then no firm is offering different or unique value. In such an industry, firms lose the ability to set price, and the overall profitability of the industry for all participants is reduced.
Economists have a name for this type of market structure—perfect competition. As an industry or market converges toward perfect competition, profitability diminishes and eventually falls to zero because all products and services are homogenous, and no single competitor has the power to set market prices. In a perfectly competitive market, every firm is a price-taker and the profit-maximizing output of each firm occurs where marginal revenue (the market price) equals marginal cost.
Fortunately, there are differences between firms in the real world, and most markets are, to varying degrees, imperfectly competitive. It is these differences that largely explain the varying levels of profitability among firms. The task of the business strategist is to understand the forces shaping competition, determine how these forces may be shifted in a firm’s favor, and identify how the firm may position itself differently than rivals and achieve rates of profitability that are superior to the industry average.
Related to the idea of competing to be the best is the mistake firms make when they confuse operational effectiveness (what Porter calls OE) with strategy. Operational effectiveness is all about being the best—using best practices and achieving excellence in the execution of a firm’s core business processes. Although operational effectiveness is an important part of being competitive and can explain some differences in profitability among firms, it is not the basis for a sustainable competitive strategy. This is because operational effectiveness is all about performing the same or similar activities better than rivals, and not about doing different things than rivals, which is the essence of strategy.
The source of superior performance in a firm is not operational excellence; rather, it is how the organization chooses to transform inputs into products and services that are worth more than the total cost of those inputs. This requires a firm to think about its value system: the value that customers need, and how it creates that value for the end user.
A firm’s value proposition is a core element of its competitive strategy and the driver of its value system. The value proposition defines the customers the firm will serve, the customer needs it will meet, and the relative price it will charge for its products or services. From there, the business strategist begins to thinks about the firm’s process for value creation and which set of activities will be optimal for fulfilling the value proposition. This takes us to Porter’s concept of the value chain—the set of discrete activities that a firm uses to create and deliver value, no matter who performs these activities.
The value chain is fundamental to a firm achieving a competitive advantage. This is because all costs have their source in the value chain, while the activities making up the value chain are also the source of the firm’s differentiation in the marketplace.
Many managers have a tactical view of their firm’s value chain and not a strategic one. A tactical view of the value chain is using best practices to improve the execution of value chain activities—this is the operational effectiveness approach alluded to above. In contrast, a strategic view of the value chain starts from the notion that the choice of how the value chain is configured will determine whether its activities will result in either a higher price or a lower cost.
A strategic view of the value chain appreciates that a firm’s value system is not just limited to itself. A firm must make upstream choices about which suppliers to involve in the value chain. A firm’s choices about suppliers, and how best to connect with them, are key determinants in a firm’s input costs and the prices it may charge customers. Similarly, a firm must also look downstream beyond just its production activities to see how it may best connect with its distributors and customers. This may also involve making choices about activities that can influence either price or cost.
Value chain analysis from a strategy perspective is therefore different than value stream or process analysis undertaken for tactical reasons. Where the tactician looks at execution and performance, the strategist looks at choices. Each choice the strategist makes about the value chain configuration will produce different value with a different cost profile. An optimal strategy results when the strategist achieves the best match of the firm’s value chain configuration to the customer’s definition of value, resulting in relative price or cost differences from the competition.
In her book, Magretta reinforces a point that Porter has made over the years: That in formulating strategy, too many firms focus on process and not content. Porter’s focus is on where a firm wants to be, not on the decision-making process by which it will get there.
In my experience, too many firms want to formulate their strategy by creating a mission statement, develop goals, brainstorm strategies, and then plan tactics. They want to follow a cookie-cutter model, even if it has been jazzed up a little by a strategy guru. This is absolutely wrong. The starting point for strategy must be to deeply understand the nature of the competitive forces in your industry and identify how industry profitability is being shaped and determined. From there, a firm can begin to see how it can exploit these forces, or reposition itself to negate their effect and generate higher rates of return.
As a strategy practitioner, I have yet to see a competitive strategy worth anything that was not underpinned by significant research and analysis. I have seen SWOT analyses—a strategic planning method used to evaluate the strengths, weaknesses/limitations, opportunities, and threats—that were all conjecture and no facts. I have seen positioning analyses that were long on qualitative claims but short on quantitative analytics. And I have seen strategic goals that could not be rationalized or supported by any detailed economic analysis of either the firm or its industry. Strategy is hard work, and there are no shortcuts or models that will make the task easy. By all means follow a structure, but don’t confuse method with content.
For too long the subject and importance of competitive strategy has been either misunderstood or relegated to the role of a planning exercise that a firm does once in a while. For too long strategy has been misrepresented by zero-sum competition—a form of rivalry where there is only one winner, and costs are reduced by shifting them onto others, whether they be customers or suppliers. Magretta’s book is a timely reminder that serves to put Porter’s thinking and concepts before us again—ideas that all firms and strategy practitioners would be well-advised to study and learn from.
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