Understanding Michael Porter
Joan Margretta
While Michael Porter’s work on strategy and competition is widely known, it is sometimes misunderstood. This book, written by a former HBR strategy editor, is intended to concisely explain Porter’s concepts. Porter was involved in the production of the book and an interview with him concludes the book.
Here is a list of ten implications for practicing this approach. A more detailed summary follows this list.
- Vying to be the best is an intuitive but self-destructive approach to competition.*
- There is no honor in size or growth if these 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 vale 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 over estimate or underestimate the importance of good execution. It’s unlikely to be a source of 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 connection 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 adapt to turbulence.
The most famous of Porter’s tools is the Five Forces model (illustrated below). A key to understanding the model is that the competition is for profits. The book suggests that companies get distracted by market share, revenue, volume or other measurements of size. Porter’s view is that the competition is for profit. The model is most easily understood by recognizing that the five forces all work to decrease a company’s profits. Strategy is developed to allow a company to escape one or more of the forces – in other words to avoid the competition.
It is easy to understand that price competition between industry participants decreases profit for the industry by transferring it to buyers. This is one of the reasons that competition to be the best often is self-destructive – the profit is transferred to buyers. Rivalry is the central force in the five Forces model and is often expressed by this profit transfer to buyers. Suppliers can also increase their share of profit by creating inputs that are not easily replaced (this may be due to natural or induced scarcity, or the result of converting a common input into a specialized input). If a business is “too” profitable, it may attract new entrants and force a price/profit reducing response to decrease the value available to the new entrant.
The most disruptive force is the alternative offering. Alternatives are often the result of under-serving or over-serving buyers. Part of the success of Amazon relative to book stores is its ability to satisfy under –served book buyers. Book stores have thousands of books, but can only present a small fraction of the books available. With rapid delivery and “infinite” selection, Amazon offers something no bookstore can.
Alternatives are most disruptive because they are usually ignored or discounted by people within an industry. The longer that a business has been stable, the less likely alternatives will seem like a real threat. Amazon has proven that people don’t really need to handle books before they buy, Travelocity has proven that they don’t need travel agent “expertise”, and Southwest has proven that travelers don’t need complex networks in air travel. Less turns out to be a valid offering and has taken profit from the established players – often reconfiguring the industry by discarding incumbents. In summary …there are a limited number of structural forces at work in every industry that systematically impact profitability in a predictable direction. Many people think there industry is unique, but this indicates that they have not thought about the model well enough yet. People may respond that prices are set by supply-and-demand, but this is only approximately true. Prices are influenced by the relative power of buyers and sellers. Prices are influenced by differences in information held by equally powerful buyers and sellers. These are not structural features of the industry. Gaining power and improving information quality are potential strategic initiatives to improve a company’s position within the structure.
Competition to be unique is a valid strategy for companies because many companies can be unique within the same industry, and each can gather a good share of profit. The center of competition to be unique is a unique value proposition. Wal-Mart provides a good example of unique value proposition. Today people associate Wal-Mart with low prices, but the original unique value proposition was supplying rural areas with affordable goods. By focusing on rural under-served areas, Wal-Mart could establish itself in the absence of real competition. To be affordable over such vast distances, the company had to be very efficient. Wal-Mart expanded in a near vacuum for decades because nobody else wanted to serve these customers and to do it cost-effectively. In other words, efficiency was a result of a strategic choice – it was not the strategic choice. Competition to be unique is much more likely to involve innovation, greater market segmentation and a deeper understanding of what buyers value – and result is greater profits.
Competitive advantage is commonly, and incorrectly, defined as what a company is good at. A company with a competitive advantage has a lower cost and/or collects a premium price compared to rivals. In other words, competitive advantage means that a company earns a greater profit for the “same” thing. The best measure of profitability for a company is the return on invested capital, which integrates a wide range of profit determinants common to an industry, according to Porter. Measures such as return on sales, market share, growth, and stock price are poor indicators of long-term competitive advantage and may drive undesirable behavior. One of the main tools of determining competitive advantage is value-chain analysis. By understanding all of the activities in the delivery of a good or service, it becomes easier to understand which steps drive cost and which drive value. Value chain analysis is both qualitative and quantitative.
- Analysis begins by identifying the basic value chains used in the industry. What activities are important both upstream and downstream for your position? What do those activities cost their users.
- Next compare your own value chain to the industry standards. Which steps incur different costs or create different values to buyers? This is where the quantitative aspects become more important because the goal is to have comparative price (value) and cost analyses for your disaggregated business compared to your competitors’ disaggregated business.
- Next, focus on those activities that create differentiation and the potential for premium pricing. There may be links between your activities and activities further down the value-chain, which create premium opportunities. Again, it is important to put the analysis into numbers.
- Finally, the disaggregated activities are subjected to cost analysis. What does it cost for each step in each of the value chains to create their offerings?
At the end of this analysis, it should be possible to understand how the various activities are related to cost and value creation, where your company has apparent advantages and disadvantages in both cost and differentiation. One important aspect of this analysis is that it is systemic. It looks beyond your own organization to those activities upstream and downstream that impact ultimate cost and value. A second important aspect of this analysis is to link the activities to value – not just cost. Managers sometimes look at all of these activities just as a cost to be minimized. This is one aspect of competition to be the best because minimal costs may lead to minimal differentiation too A good value-chain analysis also identifies the costs for downstream buyers and illuminates what they consider value and what they consider cost. By understanding the link to customer value better, opportunities for cost-effective differentiation may be identified – and differentiation is the key to strategy.
Managers often use value-chain analysis to identify areas for implementation of “best practices” or “operational excellence”. While these can have a positive effect on profitability, they are rarely the basis for an effective long-term strategy. Few best practices remain unique for long, thanks to company bragging, consultants sharing or vendors copying. Most of all, best practices tend to decrease differentiation. When everybody does the same thing in the same way, everybody produces the same value at the same cost. Profit is transferred to elsewhere in the system.
Completing an analysis of the value chain and forces facing your company sets the stage for developing a strategy, where the key objective is to create and capture value. A good strategy comprises a distinctive value proposition, a tailored value chain, trade-offs, fit across the value chain and continuity.
The value proposition is the element of strategy that looks outward at customers, at the demand side of the business. The value proposition identifies which needs, of which customers will be served at what relative price. Most industries offer many value propositions, each tailored to a specific customer and need. The better the fit of offering to need, the more likely the customer is to pay a premium price. Recognizing differences between customers, and their needs is the first step in developing a good strategy. This is often the point when over-served (over-priced) and under-served (under-priced) customers are identified.
With a value proposition identified, the value chain can be tailored to deliver that value proposition. Tailoring the value chain is the basis for cost-effective delivery of the value proposition. Without tailoring, some activities will not be related to the value proposition and increase the cost relative to the need. Southwest Airlines offers a simple example of this. Customers wanted quick convenient flights from point-to-point, but did not really place much value on different seating classes, beverages or connections. Southwest competed against full-service airlines (with lower price) and driving (saving time). By keeping the value chain simple and focused on the needs, Southwest brought its price into the range of driving costs.
Tailoring a value chain involves trade-offs, or innovations to eliminate trade-offs. Usually, an optimal value chain does one thing well. Trade-offs are the strategic equivalent of a fork in the road. If you take one path, you cannot simultaneously take the other. Some customers value frequent flyer programs. Southwest does not serve them. Some people only rent cars at airports on business expense accounts. Enterprise rents cars to people in their home towns and built a system to have lower cost of service – and has become the biggest car rental company. IKEA shoppers are almost completely self-service. People who need help need to go elsewhere; but people, who don’t need help, can save some money on decent basic furniture. Many companies want to serve everyone, but they are unlikely to be able to tailor their value chain in a way that creates superior profits. Trade-offs don’t need to be extreme to be important. Wal-Mart and Target are both discount retailers with a national footprint. Both promote low prices, but they occupy slightly different price points. Target offers some designer goods, a greater focus on clothing and fashion goods at slightly higher prices. Each company has, at times, tried to move into the other’s value proposition without success. Stock analysts make much of the Wal-Mart-Target comparison, but a more objective analysis shows that each has done well by refining their basic value proposition. Wal-Mart sacrifices “fashion” but keeps low prices, which serves some customers better. Target sacrifices volume potential and keeps higher prices, which serves other customers better. Both are very profitable because they serve different needs of their customers with tailored value chains and commitment to their trade-offs. Success means knowing which customers’ needs to say no to.
Good strategies depend on the connection among many things, on making interdependent choices. The author points out that many managers are trying to make the right decision on strategy when they need to make many right decisions. These are not independent decisions, but decisions on how to combine activities to create a unique offering. Sometimes the core value proposition requires numerous activities that seem peripheral until to study the real proposition. Using IKEA as an example, if part of the value proposition is to eliminate delivery costs, then customers must pick up the furniture at stores which requires ample parking and good access to highways. You would expect that IKEA would never build downtown. But items must fit into a car, so flat packing facilitates the customer taking the product away, but also decreases the cost of shipping for IKEA, decreases warehouse space requirements, eliminates the need for in-store assembly. Independently, all of these decrease cost, but the combination makes IKEA very distinct from conventional furniture stores.
When the activities in the value chain are well connected, they can be said to have strategic fit. Minimal fit requires that activities don’t contradict each other. A company that seeks a low-cost position and offers to do custom production runs creates a contradiction. The next step up in fit is activities that support each other. Zara, a Spanish clothing store, has its stores in high traffic locations, has large windows to show the latest fashions and has an extremely fast supply chain allowing Zara to be the first store to offer the latest trend clothing. Each factor reinforces the other. Finally, the best fit occurs when one activity allows another to be eliminated. IKEA uses in-store information to eliminate the need for in-store sales personnel. Zara’s locations make advertising unnecessary (Zara’s customers walk by and look in the windows).
Core competence is not the same as strategic fit. Some companies have outsourced activities in the basis that they are not core competencies, but have learned that these activities were part of their value proposition. Once outsourced, the activity becomes generic and less differentiated. While often easy to justify as cost reductions, they may diminish strategic capability.
Activity maps are one way to express the constellation of activities that create unique value (example below for my version of Southwest Airline’s activity map). While it might seem intuitive to try to minimize the number of elements in such a map, another way to consider the issue is to think about the ease of imitation. Each additional unique value-creating differential activity becomes one more barrier to imitation. Metaphorically, suppose you have 5 unique activities and an imitator has a 90% chance of successfully imitating each element. The probability of completely imitating your offering is less than 60%. If an offering had 10 elements, the chance would be about 1/3. When companies with long-term success are studied, a constellation of “small” activities are found that reinforce each other and create a huge barrier to competitors. The fit if these activities together means that imitators must match both the activities and the interrelationships between them. This can be an overwhelming effort that discourages potential rivals.
Finally, a good strategy requires continuity. Establishing the web of activities that create differentiated value, becoming efficient in operating the value change, and creating a presence of this differentiated value with customers takes time. Companies that are in too much of a hurry can’t implement a good strategy. Many of the companies cited here became dominant over time, not in a flash. They built up the web of skills and activities over time, learned more about customer needs and refined their value proposition. Managers currently spend so much time and effort thinking about change that they have lost sight of the importance of continuity in strategy. A well-defined strategy can both anchor an organization and liberate it for change. Continuity of strategy does not mean that an organization should stand still. As long as there is stability in the core value proposition, there can, and should, be enormous innovation in how it is delivered. Wal-Mart did not start out delivering groceries, but is the world’s largest grocer today, without changing their core value proposition. Eastman Kodak, in contrast, could not create a new strategy in the face of digital photography and is in bankruptcy, though people are taking more pictures than ever.
Continuity does not imply that the good strategists are good at predicting the future; they suffer from uncertainty as much as anybody. Though uncertainty may suggest that flexibility is the best way to proceed, Porter argues that good strategy is more important; a good strategy lets a company take a stand for something. A good value proposition has continuity in the face of uncertainty because it considers potential future competition and erects barriers against many competitive actions. Because the future threats are contemplated in the Five Forces, they can be addressed in the abstract right from the beginning. For example, Southwest Airlines only needed to know that future customers would prefer simple, inexpensive air transportation. IKEA is based on a similar insight. The details of how that would be expressed change over time – but the core strategy has not.
Porter’s description of good and bad strategies is retroactive. He examines the successful and failing, and characterizes the elements of their strategy. This underlines two problems with sort of analysis. First, it does not account for all of the companies that got the strategy right, but “failed” anyway. Survivor bias is extremely strong in these sorts of analysis. Second, it leads you to think that success was built in from the start due to good analysis and persistence. This is not correct. Successful company started out with a strategic insight based on analysis, used both analytical and intuitive thinking to evolve a tailored value chain. Southwest took four years to complete its first flight. IKEA was started in 1943, but the first IKEA store opened in 1958. Some things worked and some did not, leading to the systems in place today. Analysis did not lead to the complex web of activities, but it did set a foundation underneath it. Porter doesn’t believe that you can stumble into a good strategy either; there is a balance to be had between analysis and experience.
A good strategy has an interesting effect during uncertain times. If there is a valid analysis of the Five Forces, value proposition and value chain, then the organization can focus on execution and innovation to support the strategy rather than considering the strategy. This requires some confidence in the analysis and good communication of the strategy to stakeholders. Porter suggests that it is valuable to tell stakeholders, including competitors, what your strategy is. Let them know the stand you are taking, so that they can go elsewhere seeking value. Rational managers do not want to take on competitors head on. Equally, buyers and suppliers, who complement your strategy, will know that they want to deal with you. There may be specifics related to the value chain that are best kept a secret, but the outline of the strategy is not an important and valuable secret.
The book finishes with an extensive interview with Porter. The following Porter quotes from the interview capture some of the additional insights described.
- Strategy links choices on the demand side with unique choices about the value chain (the supply side); you can’t have competitive advantage without both.
- 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 believe that companies undermine their own strategies. Nobody does it to them. They do it themselves. Their strategies fail from within.
- 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. Managers are chasing the wrong goal.
- One of the important lessons about strategy is that if you’re pursuing a different positioning, then different metrics will be relevant. If your force everybody to show progress on the same metrics, you encourage convergence and undermine strategic uniqueness.
- Now it often happens that the current favorite eventually falls out of favor, but usually not before the analysts have herded everyone down the same path. And, of course, in strategy there is no one best path. The essence of strategy is to create your own path. You want to run your own race to reach a distinctive end point, which is the way you choose to create value.
- 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.
- I think there are a couple of keys to successful strategic planning. One is that you need to bring together the whole team responsible for a particular business, and they need to do the plan together. You can’t divide up the work and then staple it together at the end. Strategy is about the whole enterprise, not the individual pieces. That’s a fundamental principle of strategy. There is no such thing as a good marketing strategy. There is 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” best practices”, not a coherent strategy.
*text in italics is directly quoted from the book
Reactions and interpretations
- I tried to read some of Porter’s original books and gave up. I don’t remember why, but it did not seem useful to understand it at the time. If others had a similar reaction, this might explain why so many people know a part of Porter’s work without understanding the whole of it. In reading this book, I wonder what I struggled with then. It seems like a simple enough mental model and fairly complete. The content in any real case may be complicated, but the mental model is not.
- Reading between the lines of the text emphasizes that the whole of Porter’s approach is very much an exercise in system thinking. Interconnected activities, action-reaction dynamics in the Five Forces, and emergence over time are all characteristics of system thinking. I suspect that the author de-emphasized this to avoid scaring off readers. But practical application of the approach requires acknowledgement of this complexity.
- The book probably could not emphasize the importance of avoiding “competing to be best” as a strategic dead-end too much. Reading and listening to discussions about economy of scale, outsourced production, cutting costs and the like has made me wonder how much of our thinking is poisoned by competing to be the best. Companies are very busy refining their supply chains, but I wonder if they are converging on common solutions and transferring profits to customers rather than improving customer’s systems uniquely and their own profitability.
- An unfortunate consequence of the general descriptions of the work in these books is that it misses the importance of details and specifics. Many strategies are presented in such abstract terms that it is hard to know what to do to execute the strategy. I’ll give an example from my own past experience. I worked with a business that did some business with major drug producers. Cargill sold materials that would go into their fermentation media. During the process of developing a wide business strategy, an existing customer began to have trouble with one of their reactions and root cause analysis showed our ingredient to be part of the problem (part of the problem was a process change on their end that interacted with our ingredient badly). During the exchange as we tried to solve the problem we learned the following. The cost of our ingredient going into a fermentation tank was about $1000 and the value of the drug coming out was somewhere between $100,000 and $500,000. No pre-testing could identify “good” or “bad” material, and a bad run might not be apparent for 4-5 days. A bad tank was dumped because the resulting product would be “out of process” and rejected by the authorities. Our insight was that it was much more important to deliver a consistent product to these companies than it was to lower costs. In fact, if we could guarantee their productivity, we could charge a substantial premium. During this period, we learned that our material suited some fermenters very well, and others not so well at all. Because of the high risk of a new media ingredient, the entry barrier was very high. Because fermenters were generally unfamiliar with competitive media ingredients, the first barrier to switching was to make them comfortable that Cargill knew about its own ingredient. Our specific strategy in this market segment was to develop a technical information base on our ingredient and its main alternatives, share this information with our customers to improve their understanding and build relationships, and begin the process of engaging customers in testing. In some cases, it took nearly five years to get qualified as a supplier. Our principle competitors had never offered this sort of information, though they had the capability. People in the fermentation industry talked, and soon we got calls asking for help and products. For a modest amount of technical work, we increased our profit in the segment 4-5 fold, repaid our technical costs the first year, all while selling a 30-year old product with no change to the product itself. We also learned that our product was not for everyone, and we told everyone that too. As a natural product, some of it inherent nature was important and one of our competitor’s products might be better. The point of this long story is that the whole story was composed of details and specifics. Without the specific insight into the difference between input costs and output value, we would not have been able to craft a unique strategy that gathered superior profits for a number of years. We did not maintain that capability, and our profits in this segment returned to average. I am in many conversations where people want to “stay out of the weeds”, but a lot of real strategic insight and action planning is deep in the weeds. If I was going to apply root-cause analysis to the other Porter’s statement that “Most executives think they have a strategy when they really don’t”, I would point to a reluctance to get into details.
- The book only gives passing mention to analysis of how the Five Forces impacts buyers, yet one of the potentially more valuable offerings to a customer involves helping them avoid the effects of competition. This requires a detailed study of the customers’ world to generate insight, and an external perspective may see opportunities that are invisible from inside the customer’s organization. This goes way beyond asking them what they need, to analyzing their opportunities to be unique. Interestingly, this may help identify which customers are too stuck in their ways to offer opportunities.
- Finally, combining the concepts of unique value offerings and tailored supply chains helps explain the number of natural monopolies that exist. I first noticed this during the drug fermentation effort. Practically, there is one streptomycin supplier, one ampicillin supplier, and some on for 5-6 major antibiotics. Though patents explain part of this, most of these drugs were more than 25 years old. It made much more sense to let others do what they were doing and find a “new” drug to develop. Since each drug was “perfectly” defined as a compound, the only competition was to be the best. Since that is an ineffective strategy they didn’t. Note that the breakfast cereal industry is nearly the same. There is very little head-to-head competition between the major market participants. Maybe it makes sense to study cereal market share, but probably the only ways to study it strip it of meaning. The cereal companies are not competing with each other. They are competing with their suppliers and their customers for profits.
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