By Joan Magretta
I've read "On Competition" and "Competitive Strategy" by Michael Porter in the past and believe me, you don't want to go through that rigorous hell of concepts, theories and arguments.
That's why Joan Magretta does a stellar job on condensing all of Porter's essential teachings in a easily readable format; one that I always come back to anytime I need it.
This is the kind of book that will take you back to the basics and back to the drawing board whenever initiating a new project.
Amazon Page for details
My Rating: 9 / 10
Click Here to Read My Notes
I've read "On Competition" and "Competitive Strategy" by Michael Porter in the past and believe me, you don't want to go through that rigorous hell of concepts, theories and arguments.
That's why Joan Magretta does a stellar job on condensing all of Porter's essential teachings in a easily readable format; one that I always come back to anytime I need it.
This is the kind of book that will take you back to the basics and back to the drawing board whenever initiating a new project.
Amazon Page for details
My Rating: 9 / 10
Click Here to Read My Notes
if there were no competition, there would be no need for strategy.
Broadly speaking, strategy is the antidote to competition.
STRATEGY EXPLAINS how an organization, faced with competition, will achieve superior performance.
First, the right mind-set. Managers often think about competition as a form of warfare, a zero-sum battle for dominance in which only the alphas prevail. This, we’ll see in chapter 1, is a deeply flawed and destructive way of thinking.
Porter’s prescription: aim to be unique, not best. Creating value, not beating rivals, is at the heart of competition.
Michael Porter has a name for this syndrome. He calls it competition to be the best.
If you start out with this flawed idea of how competition works, it will lead you inevitably to a flawed strategy. And that will lead to mediocre performance.
In business, multiple winners can thrive and coexist.
Competition focuses more on meeting customer needs than on demolishing rivals.
Rather than enter a particular race with a particular rival, as Porter would put it, companies can choose to create their own event.
Thus, the first flaw of competition to be the best is that if an organization sets out to be the best, it sets itself an impossible goal.
This, says Porter, is competitive convergence.
This inevitable descent into price competition is the business equivalent of mutually assured destruction.
But even if this particular move benefited the industry overall, when all rivals compete on the same dimension, no one gains a competitive advantage.
There is no systematic evidence that indicates that industry leaders are the most profitable or successful firms.
To cite one notorious example, General Motors was the world’s largest car company for a period of decades, a fact that didn’t prevent its descent into bankruptcy.
Meanwhile, BMW, small by industry standards, has a history of superior returns.
Companies only have to be “big enough,” which rarely means they have to dominate.
In practice, then, head-to-head competition is rarely “perfect” for either customers or the companies that serve them. Yet Porter notes with some alarm that it is precisely this kind of zero-sum competition that has come increasingly to dominate management thinking.
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.
Strategic competition means choosing a path different from that of others.
Both plane and train will get you from Madrid to Barcelona, but the train offers a different kind of value.
Airline executives in Spain may have been defining their competition as other airlines. But customers who switch clearly don’t see it that way—and value is ultimately defined by customers.
The focus, in other words, is on creating superior value for the chosen customers, not on imitating and matching rivals.
At one extreme is competition to be the best. At the other is its polar opposite, competition to be unique.
The real point of competition is not to beat your rivals. It’s to earn profits.
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.
Porter’s research findings on the links between industry structure and profitability challenge several popular misconceptions.
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.
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.
Five forces analysis answers the key question, What’s going on out there in your industry?
Here’s the general rule: 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.
Note that if an 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.
If you have powerful buyers (that is, customers), they will use their clout to force prices down.
Powerful buyers will force prices down or demand more value in the product, thus capturing more of the value for themselves.
If you have powerful suppliers, they will use their negotiating leverage to charge higher prices or to insist on more favorable terms.
Powerful suppliers will charge higher prices or insist on more favorable terms, lowering industry profitability.
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.
Entry barriers protect an industry from newcomers who would add new capacity.
If rivalry is intense, companies compete away the value they create, passing it on to buyers in lower prices or dissipating it in higher costs of competing.
Why Only Five Forces? The five forces framework applies in all industries for the simple reason that it encompasses relationships fundamental to all commerce: those between buyers and sellers, between sellers and suppliers, between rival sellers, and between supply and demand. Think about it. This covers all of the bases. The five forces are universal and fundamental.
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.
In perfect competition there are no profits because price is always driven down to the marginal cost of production.
Other factors may be important, but they are not structural. Consider four that get the most attention:
Government regulation
technology.
Managers often mistakenly assume that a high-growth industry will be an attractive one. But growth is no guarantee that the industry will be profitable.
Growth alone says nothing about the power of customers or the availability of substitutes.
The untested assumption that a fast-growing industry is a “good” industry, Porter warns, often leads to bad strategy decisions.
Finally, complements are sometimes proposed as a “sixth force.”
How the five forces impact profitability
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.
Typical Steps in Industry Analysis
Define the relevant industry by both its product scope and geographic scope.
Identify the players constituting each of the five forces and, where appropriate, segment them into groups.
Assess the underlying drivers of each force.
Step back and assess the overall industry structure.
Analyze recent and likely future changes for each force.
How can you position yourself in relation to the five forces?
But using five forces analysis simply to declare that an industry is attractive or unattractive misses its full power.
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.
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.
The real point of competition is earning profits, not taking business away from your rivals.
Companies compete for profits with their direct rivals, but also with their customers, their suppliers, potential new entrants, and substitutes.
The collective strength of the five forces determines the average profitability of the industry through their impact on prices, costs, and the investment required to compete.
Using five forces analysis simply to declare that an industry is attractive or unattractive misses its full power as a tool.
Industry structure is dynamic, not static.
NO TERM IS MORE closely associated with Porter than competitive advantage. You hear it in companies all the time, but rarely as Porter intended.
For Porter, competitive advantage is not about trouncing rivals, it’s about creating superior value.
If you have a real competitive advantage, it means that compared with rivals, you operate at a lower cost, command a premium price, or both. These are the only ways that one company can outperform another.
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).
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.
Stock price, Porter warns, is a meaningful measure of economic value only over the long run.
Strategy, then, must start not only with the right goal, but also with a commitment to measure performance accurately and honestly.
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.
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.
The ability to command a higher price is the essence of differentiation, a term Porter uses in this somewhat idiosyncratic way.
The second component of superior profitability is relative cost—that is, you manage somehow to produce at lower cost than your rivals.
Strategy choices aim to shift relative price or relative cost in a company’s favor.
If your value chain looks like everyone else’s, then you are engaged in competition to be the best.
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.
Matching the value chain—the activities performed inside the company—to the customer’s definition of value was a new way of thinking just twenty-five years ago.
Using Porter’s value chain construct was like looking through a microscope for the first time. Suddenly managers could see a whole world of relationships that had previously been invisible to them.
Wherever a company has achieved competitive advantage, there must be differences in activities.
A company can be better at performing the same configuration of activities, or it can choose a different configuration of activities.
The important thing is not to confuse OE with strategy.
Competing on best practices effectively raises the bar for everyone. While there is absolute improvement in OE, there is relative improvement for no one.
The inevitable diffusion of best practices means that everyone has to run faster just to stay in place.
No one has been better at OE competition than the Japanese, but, as Porter’s work documents in great detail, OE competition has led even the best of them to chronically poor profitability.
Strategy is the antidote to competitive rivalry.
Popular metrics such as shareholder value, return on sales, growth, and market share are misleading for strategy.
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 means you will be able to sustain higher relative prices or lower relative costs, or both, than your rivals in an industry.
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.
five tests every good strategy must pass: A distinctive value proposition A tailored value chain Trade-offs different from rivals Fit across value chain Continuity over time.
But recall the definition of competitive advantage: a difference in relative price or relative costs that arises because of differences in the activities being performed.
Your value chain must be specifically tailored to deliver your value proposition.
Strategy means deliberately choosing a different set of activities to deliver a unique mix of value.
If all rivals produce the same way, distribute the same way, service the same way, and so on, they are, in Porter’s terms, competing to be the best, and not competing on strategy.
Porter defines the value proposition as the answer to three fundamental questions (see figure 4-1): Which customers are you going to serve? Which needs are you going to meet? What relative price will provide acceptable value for customers and acceptable profitability for the company?
The value proposition is the element of strategy that looks outward at customers, at the demand side of the business. The value chain focuses internally on operations. Strategy is fundamentally integrative, bringing the demand and supply sides together.
Although people tend to think of Walmart as a fierce competitor, Walmart started out by completely avoiding head-to-head competition.
Here’s what is essential: finding a unique way to serve your chosen segment profitably.
Some value propositions target customers who are overserved (and hence overpriced) by other offerings in the industry. A company can win these customers by eliminating unnecessary costs and meeting “just enough” of their needs.
Southwest didn’t figure out every element of its value proposition on Day One. Companies rarely do. It learned by doing.
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 by Porter’s definition, you don’t have a strategy.
In other words, limits make it possible to develop a value chain that is different from that of rivals who have chosen to offer a different kind of value.
This is a crucially important test that should be applied to any strategy. If the same value chain can deliver different value propositions equally well, then those value propositions have no strategic relevance.
Even when an industry produces something that looks like a homogenous product, Porter points to many opportunities up and down the value chain for differentiation—in delivery, in disposal, in certification and testing, and in financing, to name just a few dimensions.
“Strategic competition,” Porter writes, “can be thought of as the process of perceiving new positions that woo customers from established positions or draw new customers into the market.”
But how do companies, in practice, actually find new positions? Looking for new ways to segment customers or to serve unmet needs is one starting point. But the value chain—the unique set of activities your company performs—is an equally valid starting point.
Proprietary is a key word in this story. Grace Manufacturing didn’t just have a strength in making sharp things. Most essential for strategy, it had a unique strength.
Discovering new positions is a creative act.
By definition, strategy is about creating something unique, making a set of choices that nobody else has made.
Trade-offs are the strategic equivalent of a fork in the road. If you take one path, you cannot simultaneously take the other.
Competition is full of economic trade-offs. These lie at the very heart of strategy.
Robust strategies typically incorporate multiple trade-offs. The very best have trade-offs at almost every step in the value chain.
In choosing its particular kind of value and the activities needed to deliver it, IKEA has accepted a set of limits: it does not meet all the needs of all customers.
By their very nature, trade-offs are choices that make strategies sustainable because they are not easy to match or to neutralize.
Trade-offs impose real economic penalties for companies that try to compete in two ways at once.
British Airways took this lesson to heart: 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.
Trade-offs are choices that make strategies sustainable because they are not easy to match or to neutralize.
Trade-offs make choices about what not to do as important as choices of what to do.
Deciding which needs to serve and which products to offer is absolutely key to developing a strategy.
But it is just as important to decide which needs you will not serve, and which products, features, or services you won’t offer.
Building and sustaining competitive advantage means that you must be disciplined about saying no to a host of initiatives that would blur your uniqueness.
The notion that the customer is always right is one of those half-truths that can lead to mediocre performance.
Good strategies depend on the connection among many things, on making interdependent choices.
Fit means that the value or cost of one activity is affected by the way other activities are performed.
Porter has created a tool he calls an “activity system map” to chart a company’s significant activities, their relationship to the value proposition, and to each other.
Where does competitive advantage come from? In many companies, the search for competitive advantage focuses on what are variously called critical resources, core capabilities, or key success factors.
All reflect a similar point of view: that competitive advantage comes from a small number of factors, be they intangible skills or hard assets. The way to compete, then, is to acquire and develop those core competences.
A common mistake in strategy is to choose the same core competences as everyone else in your industry.
Fit means that the whole matters more than any individual part, that many things together create value, not just a few things in isolation.
What, for example, accounts for Zara’s success? Is it Zara’s flair for fashion? Its flexible European manufacturing? Its store locations? Its approach to logistics?
The answer lies in the fit among all of Zara’s value-creating activities. Zara’s strategy involves a series of choices made simultaneously. Zara’s success depends on a whole system of interdependent activities, not just one or two powerful parts. It comes not only from the trade-offs Zara has made in configuring its activities but also from the way those activities impact each other.
Fit means that the competitive value of individual activities—and the associated skills, competences, or resources—cannot be decoupled from the system or the strategy.
Fit not only amplifies competitive advantage by enhancing value or lowering costs, but also makes that advantage more sustainable.
By throwing multiple obstacles in the path of would-be imitators, fit lowers the odds that a strategy can be copied.
There is a subtle corollary to this last point. Porter observes that companies with strong fit are typically superior in both strategy and execution, and thus they are less likely to attract imitators in the first place.
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.
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.
The sign of a good strategy is that it deliberately makes some customers unhappy.
Good strategies depend on many choices, not one, and on the connections among them.
Porter: 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. This is a hard race to win. So many managers confuse operational effectiveness with strategy.
Another common mistake is confusing marketing with strategy.
But a robust strategy requires a tailored value chain—it’s about the supply side as well, the unique configuration of activities that delivers value.
Another common mistake is getting the definition of the business wrong, or getting the geographic scope wrong.
Similarly, there has been a tendency to define industries as global when they are national or encompass only groups of neighboring countries.
Companies, mindful of the drumbeat about globalization, internationalize without understanding the true economics of their business.
The value chain is the principal tool to delineate the geographic boundaries of competition, to determine how local or how global that business is.
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 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.
Strategy is not about making every customer happy.
When you’ve got your strategist’s hat on, you want to decide which customers and which needs you want to meet.
I also believe that as capital markets have evolved they have become more and more toxic for strategy.
The single-minded pursuit of shareholder value, measured over the short term, has been enormously destructive for strategy and value creation.
Capital markets have become toxic for strategy. The single-minded pursuit of shareholder value . . . has been enormously destructive for strategy and value creation.
Having a strategy in the first place is hard. Maintaining a strategy is even harder.
The pressure to grow is among the greatest threats to strategy.
Too often, companies believe that any growth is good growth. They have a tendency to overshoot, by adding product lines, market segments, or geographies that blur uniqueness, create compromises, reduce fit, and ultimately undermine competitive advantage.
My advice is to concentrate on deepening and extending a strategic position rather than broadening and ultimately compromising it.
First, never copy.
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.
Third, expand geographically in a focused way. If you’ve penetrated your strategic opportunity at home, there’s always the rest of the world.
When you go to a foreign market, remember that you’re not trying to serve the whole market. You’re looking for the segment that values what you do.
Another key characteristic of successful internationalization is that you’ve got to get direct contact with the customer.
If somebody else is representing your product and listening to customers, how can you have a strategy?
Foreign acquisitions must be forcefully repositioned around your strategy, not allowed to continue theirs (unless, of course, theirs is better!).
But geographic expansion can actually be a very powerful way of leveraging and growing your strategy if you do it the right way.
People who believe that industry structure no longer matters are likely to be the same people who see every new technology or management innovation as “disruptive.” But you’ve got to be careful because the data simply doesn’t support that view.
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.
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?
Disruptive technology is compelling as a metaphor, but managers need to be rigorous about what’s creating the disruption.
The term “business model” is widely used, but it’s not precisely defined. So as with the word “strategy,” it unfortunately can mean a lot of different things to different people.
But here’s where I think the concept can be useful. If you’re starting a new business and you’re not yet sure whether or how it’s going to work, the business model concept helps you to focus in on the most basic question of all: How are we going to make money? What will our costs look like? Where will our revenue come from? How can this business be profitable?
But the business model doesn’t help you to develop or to assess competitive advantage, which is what strategy aims to do.
Strategy goes beyond the basic viability question, Can we make money?
Strategy asks a more complicated question, How can we make more money than our rivals, how can we generate superior returns, and then, How can we sustain that advantage over time?
A business model highlights the relationship between your revenues and your costs.
So the business model is best used as the most basic step in thinking about the viability of a company.
If you want to achieve superior profitability (or avoid inferior profitability) and stay viable, then strategy—as I define it—will take you to the next level.
There’s more uncertainty about the shape of things, but the five forces exercise is fundamentally the same with one big exception: instead of analyzing what already exists, you’re forecasting.
There is no such thing as a market where competition is irrelevant, as nice as that might sound.
So you have to have a hypothesis for how the industry might take shape once there is an industry.
Strategy is necessary for any type of organization that serves customers or meets needs. Good strategy for any organization starts with defining appropriate goals.
Strategic planning often becomes a time-consuming ritual that really doesn’t support strategic thinking at all.
Strategy is about the whole enterprise, not the individual pieces.
There’s no such thing as a good marketing strategy. There’s only a good marketing strategy in the context of the overall strategy.
Planning needs to support thinking rather than drive it out.
important. Strategy is useless if it’s a secret, if nobody else in the organization knows what the strategy is.
The purpose of strategy is to align the behavior of everyone in the organization and to help them make good choices when they’re on their own.
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.
The employee dialogues always start with, What do we stand for as a company? What makes us distinctive? How are we unique? And it goes on from there.
I also believe that you should communicate your strategy to your customers, to your suppliers, to your channels, and to the capital markets.
Don’t assume that stock analysts will figure it out. You’ve got to tell them.
If your competitor hears you give a speech about your strategy, so much the better.
And finally, if there are individuals who don’t accept the strategy, who simply refuse to get on board, they cannot have an ongoing role in the company.
It’s not about democracy, or consensus, or about making everyone happy. Fundamentally, it’s about picking a direction and then getting everybody really excited about it.
Broadly speaking, strategy is the antidote to competition.
STRATEGY EXPLAINS how an organization, faced with competition, will achieve superior performance.
First, the right mind-set. Managers often think about competition as a form of warfare, a zero-sum battle for dominance in which only the alphas prevail. This, we’ll see in chapter 1, is a deeply flawed and destructive way of thinking.
Porter’s prescription: aim to be unique, not best. Creating value, not beating rivals, is at the heart of competition.
Michael Porter has a name for this syndrome. He calls it competition to be the best.
If you start out with this flawed idea of how competition works, it will lead you inevitably to a flawed strategy. And that will lead to mediocre performance.
In business, multiple winners can thrive and coexist.
Competition focuses more on meeting customer needs than on demolishing rivals.
Rather than enter a particular race with a particular rival, as Porter would put it, companies can choose to create their own event.
Thus, the first flaw of competition to be the best is that if an organization sets out to be the best, it sets itself an impossible goal.
This, says Porter, is competitive convergence.
This inevitable descent into price competition is the business equivalent of mutually assured destruction.
But even if this particular move benefited the industry overall, when all rivals compete on the same dimension, no one gains a competitive advantage.
There is no systematic evidence that indicates that industry leaders are the most profitable or successful firms.
To cite one notorious example, General Motors was the world’s largest car company for a period of decades, a fact that didn’t prevent its descent into bankruptcy.
Meanwhile, BMW, small by industry standards, has a history of superior returns.
Companies only have to be “big enough,” which rarely means they have to dominate.
In practice, then, head-to-head competition is rarely “perfect” for either customers or the companies that serve them. Yet Porter notes with some alarm that it is precisely this kind of zero-sum competition that has come increasingly to dominate management thinking.
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.
Strategic competition means choosing a path different from that of others.
Both plane and train will get you from Madrid to Barcelona, but the train offers a different kind of value.
Airline executives in Spain may have been defining their competition as other airlines. But customers who switch clearly don’t see it that way—and value is ultimately defined by customers.
The focus, in other words, is on creating superior value for the chosen customers, not on imitating and matching rivals.
At one extreme is competition to be the best. At the other is its polar opposite, competition to be unique.
The real point of competition is not to beat your rivals. It’s to earn profits.
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.
Porter’s research findings on the links between industry structure and profitability challenge several popular misconceptions.
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.
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.
Five forces analysis answers the key question, What’s going on out there in your industry?
Here’s the general rule: 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.
Note that if an 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.
If you have powerful buyers (that is, customers), they will use their clout to force prices down.
Powerful buyers will force prices down or demand more value in the product, thus capturing more of the value for themselves.
If you have powerful suppliers, they will use their negotiating leverage to charge higher prices or to insist on more favorable terms.
Powerful suppliers will charge higher prices or insist on more favorable terms, lowering industry profitability.
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.
Entry barriers protect an industry from newcomers who would add new capacity.
If rivalry is intense, companies compete away the value they create, passing it on to buyers in lower prices or dissipating it in higher costs of competing.
Why Only Five Forces? The five forces framework applies in all industries for the simple reason that it encompasses relationships fundamental to all commerce: those between buyers and sellers, between sellers and suppliers, between rival sellers, and between supply and demand. Think about it. This covers all of the bases. The five forces are universal and fundamental.
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.
In perfect competition there are no profits because price is always driven down to the marginal cost of production.
Other factors may be important, but they are not structural. Consider four that get the most attention:
Government regulation
technology.
Managers often mistakenly assume that a high-growth industry will be an attractive one. But growth is no guarantee that the industry will be profitable.
Growth alone says nothing about the power of customers or the availability of substitutes.
The untested assumption that a fast-growing industry is a “good” industry, Porter warns, often leads to bad strategy decisions.
Finally, complements are sometimes proposed as a “sixth force.”
How the five forces impact profitability
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.
Typical Steps in Industry Analysis
Define the relevant industry by both its product scope and geographic scope.
Identify the players constituting each of the five forces and, where appropriate, segment them into groups.
Assess the underlying drivers of each force.
Step back and assess the overall industry structure.
Analyze recent and likely future changes for each force.
How can you position yourself in relation to the five forces?
But using five forces analysis simply to declare that an industry is attractive or unattractive misses its full power.
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.
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.
The real point of competition is earning profits, not taking business away from your rivals.
Companies compete for profits with their direct rivals, but also with their customers, their suppliers, potential new entrants, and substitutes.
The collective strength of the five forces determines the average profitability of the industry through their impact on prices, costs, and the investment required to compete.
Using five forces analysis simply to declare that an industry is attractive or unattractive misses its full power as a tool.
Industry structure is dynamic, not static.
NO TERM IS MORE closely associated with Porter than competitive advantage. You hear it in companies all the time, but rarely as Porter intended.
For Porter, competitive advantage is not about trouncing rivals, it’s about creating superior value.
If you have a real competitive advantage, it means that compared with rivals, you operate at a lower cost, command a premium price, or both. These are the only ways that one company can outperform another.
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).
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.
Stock price, Porter warns, is a meaningful measure of economic value only over the long run.
Strategy, then, must start not only with the right goal, but also with a commitment to measure performance accurately and honestly.
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.
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.
The ability to command a higher price is the essence of differentiation, a term Porter uses in this somewhat idiosyncratic way.
The second component of superior profitability is relative cost—that is, you manage somehow to produce at lower cost than your rivals.
Strategy choices aim to shift relative price or relative cost in a company’s favor.
If your value chain looks like everyone else’s, then you are engaged in competition to be the best.
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.
Matching the value chain—the activities performed inside the company—to the customer’s definition of value was a new way of thinking just twenty-five years ago.
Using Porter’s value chain construct was like looking through a microscope for the first time. Suddenly managers could see a whole world of relationships that had previously been invisible to them.
Wherever a company has achieved competitive advantage, there must be differences in activities.
A company can be better at performing the same configuration of activities, or it can choose a different configuration of activities.
The important thing is not to confuse OE with strategy.
Competing on best practices effectively raises the bar for everyone. While there is absolute improvement in OE, there is relative improvement for no one.
The inevitable diffusion of best practices means that everyone has to run faster just to stay in place.
No one has been better at OE competition than the Japanese, but, as Porter’s work documents in great detail, OE competition has led even the best of them to chronically poor profitability.
Strategy is the antidote to competitive rivalry.
Popular metrics such as shareholder value, return on sales, growth, and market share are misleading for strategy.
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 means you will be able to sustain higher relative prices or lower relative costs, or both, than your rivals in an industry.
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.
five tests every good strategy must pass: A distinctive value proposition A tailored value chain Trade-offs different from rivals Fit across value chain Continuity over time.
But recall the definition of competitive advantage: a difference in relative price or relative costs that arises because of differences in the activities being performed.
Your value chain must be specifically tailored to deliver your value proposition.
Strategy means deliberately choosing a different set of activities to deliver a unique mix of value.
If all rivals produce the same way, distribute the same way, service the same way, and so on, they are, in Porter’s terms, competing to be the best, and not competing on strategy.
Porter defines the value proposition as the answer to three fundamental questions (see figure 4-1): Which customers are you going to serve? Which needs are you going to meet? What relative price will provide acceptable value for customers and acceptable profitability for the company?
The value proposition is the element of strategy that looks outward at customers, at the demand side of the business. The value chain focuses internally on operations. Strategy is fundamentally integrative, bringing the demand and supply sides together.
Although people tend to think of Walmart as a fierce competitor, Walmart started out by completely avoiding head-to-head competition.
Here’s what is essential: finding a unique way to serve your chosen segment profitably.
Some value propositions target customers who are overserved (and hence overpriced) by other offerings in the industry. A company can win these customers by eliminating unnecessary costs and meeting “just enough” of their needs.
Southwest didn’t figure out every element of its value proposition on Day One. Companies rarely do. It learned by doing.
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 by Porter’s definition, you don’t have a strategy.
In other words, limits make it possible to develop a value chain that is different from that of rivals who have chosen to offer a different kind of value.
This is a crucially important test that should be applied to any strategy. If the same value chain can deliver different value propositions equally well, then those value propositions have no strategic relevance.
Even when an industry produces something that looks like a homogenous product, Porter points to many opportunities up and down the value chain for differentiation—in delivery, in disposal, in certification and testing, and in financing, to name just a few dimensions.
“Strategic competition,” Porter writes, “can be thought of as the process of perceiving new positions that woo customers from established positions or draw new customers into the market.”
But how do companies, in practice, actually find new positions? Looking for new ways to segment customers or to serve unmet needs is one starting point. But the value chain—the unique set of activities your company performs—is an equally valid starting point.
Proprietary is a key word in this story. Grace Manufacturing didn’t just have a strength in making sharp things. Most essential for strategy, it had a unique strength.
Discovering new positions is a creative act.
By definition, strategy is about creating something unique, making a set of choices that nobody else has made.
Trade-offs are the strategic equivalent of a fork in the road. If you take one path, you cannot simultaneously take the other.
Competition is full of economic trade-offs. These lie at the very heart of strategy.
Robust strategies typically incorporate multiple trade-offs. The very best have trade-offs at almost every step in the value chain.
In choosing its particular kind of value and the activities needed to deliver it, IKEA has accepted a set of limits: it does not meet all the needs of all customers.
By their very nature, trade-offs are choices that make strategies sustainable because they are not easy to match or to neutralize.
Trade-offs impose real economic penalties for companies that try to compete in two ways at once.
British Airways took this lesson to heart: 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.
Trade-offs are choices that make strategies sustainable because they are not easy to match or to neutralize.
Trade-offs make choices about what not to do as important as choices of what to do.
Deciding which needs to serve and which products to offer is absolutely key to developing a strategy.
But it is just as important to decide which needs you will not serve, and which products, features, or services you won’t offer.
Building and sustaining competitive advantage means that you must be disciplined about saying no to a host of initiatives that would blur your uniqueness.
The notion that the customer is always right is one of those half-truths that can lead to mediocre performance.
Good strategies depend on the connection among many things, on making interdependent choices.
Fit means that the value or cost of one activity is affected by the way other activities are performed.
Porter has created a tool he calls an “activity system map” to chart a company’s significant activities, their relationship to the value proposition, and to each other.
Where does competitive advantage come from? In many companies, the search for competitive advantage focuses on what are variously called critical resources, core capabilities, or key success factors.
All reflect a similar point of view: that competitive advantage comes from a small number of factors, be they intangible skills or hard assets. The way to compete, then, is to acquire and develop those core competences.
A common mistake in strategy is to choose the same core competences as everyone else in your industry.
Fit means that the whole matters more than any individual part, that many things together create value, not just a few things in isolation.
What, for example, accounts for Zara’s success? Is it Zara’s flair for fashion? Its flexible European manufacturing? Its store locations? Its approach to logistics?
The answer lies in the fit among all of Zara’s value-creating activities. Zara’s strategy involves a series of choices made simultaneously. Zara’s success depends on a whole system of interdependent activities, not just one or two powerful parts. It comes not only from the trade-offs Zara has made in configuring its activities but also from the way those activities impact each other.
Fit means that the competitive value of individual activities—and the associated skills, competences, or resources—cannot be decoupled from the system or the strategy.
Fit not only amplifies competitive advantage by enhancing value or lowering costs, but also makes that advantage more sustainable.
By throwing multiple obstacles in the path of would-be imitators, fit lowers the odds that a strategy can be copied.
There is a subtle corollary to this last point. Porter observes that companies with strong fit are typically superior in both strategy and execution, and thus they are less likely to attract imitators in the first place.
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.
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.
The sign of a good strategy is that it deliberately makes some customers unhappy.
Good strategies depend on many choices, not one, and on the connections among them.
Porter: 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. This is a hard race to win. So many managers confuse operational effectiveness with strategy.
Another common mistake is confusing marketing with strategy.
But a robust strategy requires a tailored value chain—it’s about the supply side as well, the unique configuration of activities that delivers value.
Another common mistake is getting the definition of the business wrong, or getting the geographic scope wrong.
Similarly, there has been a tendency to define industries as global when they are national or encompass only groups of neighboring countries.
Companies, mindful of the drumbeat about globalization, internationalize without understanding the true economics of their business.
The value chain is the principal tool to delineate the geographic boundaries of competition, to determine how local or how global that business is.
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 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.
Strategy is not about making every customer happy.
When you’ve got your strategist’s hat on, you want to decide which customers and which needs you want to meet.
I also believe that as capital markets have evolved they have become more and more toxic for strategy.
The single-minded pursuit of shareholder value, measured over the short term, has been enormously destructive for strategy and value creation.
Capital markets have become toxic for strategy. The single-minded pursuit of shareholder value . . . has been enormously destructive for strategy and value creation.
Having a strategy in the first place is hard. Maintaining a strategy is even harder.
The pressure to grow is among the greatest threats to strategy.
Too often, companies believe that any growth is good growth. They have a tendency to overshoot, by adding product lines, market segments, or geographies that blur uniqueness, create compromises, reduce fit, and ultimately undermine competitive advantage.
My advice is to concentrate on deepening and extending a strategic position rather than broadening and ultimately compromising it.
First, never copy.
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.
Third, expand geographically in a focused way. If you’ve penetrated your strategic opportunity at home, there’s always the rest of the world.
When you go to a foreign market, remember that you’re not trying to serve the whole market. You’re looking for the segment that values what you do.
Another key characteristic of successful internationalization is that you’ve got to get direct contact with the customer.
If somebody else is representing your product and listening to customers, how can you have a strategy?
Foreign acquisitions must be forcefully repositioned around your strategy, not allowed to continue theirs (unless, of course, theirs is better!).
But geographic expansion can actually be a very powerful way of leveraging and growing your strategy if you do it the right way.
People who believe that industry structure no longer matters are likely to be the same people who see every new technology or management innovation as “disruptive.” But you’ve got to be careful because the data simply doesn’t support that view.
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.
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?
Disruptive technology is compelling as a metaphor, but managers need to be rigorous about what’s creating the disruption.
The term “business model” is widely used, but it’s not precisely defined. So as with the word “strategy,” it unfortunately can mean a lot of different things to different people.
But here’s where I think the concept can be useful. If you’re starting a new business and you’re not yet sure whether or how it’s going to work, the business model concept helps you to focus in on the most basic question of all: How are we going to make money? What will our costs look like? Where will our revenue come from? How can this business be profitable?
But the business model doesn’t help you to develop or to assess competitive advantage, which is what strategy aims to do.
Strategy goes beyond the basic viability question, Can we make money?
Strategy asks a more complicated question, How can we make more money than our rivals, how can we generate superior returns, and then, How can we sustain that advantage over time?
A business model highlights the relationship between your revenues and your costs.
So the business model is best used as the most basic step in thinking about the viability of a company.
If you want to achieve superior profitability (or avoid inferior profitability) and stay viable, then strategy—as I define it—will take you to the next level.
There’s more uncertainty about the shape of things, but the five forces exercise is fundamentally the same with one big exception: instead of analyzing what already exists, you’re forecasting.
There is no such thing as a market where competition is irrelevant, as nice as that might sound.
So you have to have a hypothesis for how the industry might take shape once there is an industry.
Strategy is necessary for any type of organization that serves customers or meets needs. Good strategy for any organization starts with defining appropriate goals.
Strategic planning often becomes a time-consuming ritual that really doesn’t support strategic thinking at all.
Strategy is about the whole enterprise, not the individual pieces.
There’s no such thing as a good marketing strategy. There’s only a good marketing strategy in the context of the overall strategy.
Planning needs to support thinking rather than drive it out.
important. Strategy is useless if it’s a secret, if nobody else in the organization knows what the strategy is.
The purpose of strategy is to align the behavior of everyone in the organization and to help them make good choices when they’re on their own.
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.
The employee dialogues always start with, What do we stand for as a company? What makes us distinctive? How are we unique? And it goes on from there.
I also believe that you should communicate your strategy to your customers, to your suppliers, to your channels, and to the capital markets.
Don’t assume that stock analysts will figure it out. You’ve got to tell them.
If your competitor hears you give a speech about your strategy, so much the better.
And finally, if there are individuals who don’t accept the strategy, who simply refuse to get on board, they cannot have an ongoing role in the company.
It’s not about democracy, or consensus, or about making everyone happy. Fundamentally, it’s about picking a direction and then getting everybody really excited about it.