Understanding Michael Porter by Joan Magretta

How strongly I recommend this book: 8 / 10

Date read: July 14, 2022

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Summary

Absolutely loved this book. I came in looking to understand Porter’s Five Forces better, and I left with spending more time on his fundamental ideas on strategy.

Most companies compete to be the best. This is the starting point of where most strategies go wrong. Strategy is not a zero-sum game, it’s about identifying the unserved needs of customers. It’s about making a choice on which customer to not serve. It’s about doubling down on areas where the company has an unfair advantage in the industry. This book covers it all. I also recommend reading my notes on Good Strategy Bad Strategy for more on strategy.

I’ve summarized this book in detail in my newsletter here, and below are my top highlights from each chapter. I’ve also used this framework to analyze the AI product, Cursor.

Favorite Quotes and Chapter Notes

I went through my notes and progressively capture key quotes from all chapters below.

P.S. – Highly recommend Readwise if you want to get the most out of your reading.

Part One: What Is Competition?

• 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. The key to competitive success— for businesses and nonprofits alike— lies in an organization’s ability to create unique value. Porter’s prescription: aim to be unique, not best. Creating value, not beating rivals, is at the heart of competition.

1. Competition: The Right Mind-Set

• STRATEGY IS ONE OF the most dangerous concepts in business. Why dangerous? Because while most managers agree that it is terrifically important, once you start paying attention to how the word is used you will soon be wondering whether it means anything at all.
• Strategy explains how an organization, faced with competition, will achieve superior performance. The definition is deceptively simple.
• One of the reasons so many companies fail to develop good strategies is that the people running them operate with fundamental misconceptions about what competition is and how it works.
• How you think about competition will define the choices you make about how you are going to compete. It will impact your ability to assess those choices critically. That is why before we can even begin to talk about strategy, we need to tackle the question of competition and competitive advantage.
• If you want to win, it’s obvious that you should be the best. Or is it? Michael Porter has a name for this syndrome. He calls it competition to be the best. It is, he will tell you, absolutely the wrong way to think about competition. 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. Just look around. Because there are so many needs to serve, there are many ways to win.
• In the vast majority of businesses, there is simply no such thing as”the best.”
• If rivals all pursue the”one best way” to compete, they will find themselves on a collision course. Everyone in the industry will listen to the same advice and follow the same prescription.
• The airline industry has suffered from this sort of competition for decades. If American Airlines tries to win new customers by offering free meals on its New York to Miami route, then Delta will be forced to match it— leaving both companies worse off. Both will have incurred added costs, but neither will be able to charge more, and neither will end up with more seats filled. Every time one company makes a move, its rivals will jump to match it. With everyone chasing after the same customer, there will be a contest over every sale. This, says Porter, is competitive convergence. Over time, rivals begin to look alike as one difference after another erodes.
• Companies only have to be”big enough,” which rarely means they have to dominate. Often”big enough” is just 10 percent of the market. Yet companies under the influence of winner-takes-all thinking tend to pursue illusory scale advantages. In doing so, they are likely to damage their own performance by cutting price to gain volume, by overextending themselves to serve all market segments, and by pursuing overpriced mergers and acquisitions. The auto industry over the past couple of decades has exhibited all of the above tendencies, to disastrous effect.
• But Isn’t”The Best” Good for Customers?
• The lesson taught in Econ 101 is that what’s good for customers(lower prices) is bad for companies(lower profits), and vice versa. But Porter offers a more nuanced and complex view of what actually happens when companies compete to be the best. Customers may benefit from lower prices as rivals imitate and match each other’s offerings, but they may also be forced to sacrifice choice. When an industry converges around a standard offering, the”average” customer may fare well. But remember that averages are made up of some customers who want more and some who want less. There will be individuals in both groups who will not be well served by the average.
• When choice is limited, value is often destroyed. As a customer, you are either paying too much for extras you don’t want, or you are forced to make do with what’s offered, even if it’s not really what you need.
• Competition to Be Unique
• 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. This concept is all about value. It’s about uniqueness in the value you create and how you create it.
• Competition to be unique reflects a different mind-set and a different way of thinking about the nature of competition. Here, companies pursue distinctive ways of competing aimed at serving different sets of needs and customers. The focus, in other words, is on creating superior value for the chosen customers, not on imitating and matching rivals.
• A better analogy than war or sports might be the performing arts. There can be many good singers or actors— each outstanding and successful in a distinctive way. Each finds and creates an audience. The more good performers there are, the more audiences grow and the arts flourish. This kind of value creation is the essence of positive-sum competition.
• Competing to be the best feeds on imitation. Competing to be unique thrives on innovation.
• There is nothing foreordained or predetermined about the path that industries take to zero-sum or to positive-sum competition.
• Competition to be unique, Porter’s work teaches, can make life better across almost all fields of human endeavor— but only if managers understand that their choices will influence the kind of competition that prevails in their industry. These are choices with enormously high stakes. Given the complexity of the manager’s job, it is hardly surprising that so many hunger for simplification— a single recipe for success. It’s the fast food of business thinking. But beware of anyone who claims there is only one way to win. If there were only one best way to compete, Porter reasons, many, if not all, companies would adopt it.
• Instead, competition is multidimensional, and strategy is about making choices along many dimensions, not just one. No single prescription about which choices to make is valid for every company in every industry.

2. The Five Forces: Competing for Profits

• Here we’ll tackle another big misconception. Most people think of competition as a direct contest between rivals.
• The real point of competition is not to beat your rivals. It’s not about winning a sale. The point is to earn profits. Competing for profits is more complex.
• These five forces— the intensity of rivalry among existing competitors, the bargaining power of buyers(the industry’s customers), the bargaining power of suppliers, the threat of substitutes, and the threat of new entrants— determine the industry’s structure, an important concept that may sound academic but is not(figure 2-1).
• 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. Structure trumps these other, more intuitive, categories.
• Industry structure is surprisingly sticky. Despite the prevailing sense that business changes with incredible rapidity, Porter discovered that industry structure— once an industry passes beyond its emerging, prestructure phase— tends to be quite stable over time. New products come and go. New technologies come and go. Things change all the time. But structural change— and therefore change in the average profitability of an industry— usually takes a long time.
• Remember that strategy explains how an organization, faced with competition, will achieve superior performance. The five forces framework zeroes in on the competition you face and gives you the baseline for measuring superior performance. It explains the industry’s average prices and costs, and therefore the average industry profitability you are trying to beat. Before you can make sense of your own performance(current and potential), you need insight into the industry’s fundamental economics.
• 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.
• Within a given industry, the relative strength of the five forces and their specific configuration determine the industry’s profit potential because they directly impact the industry’s prices and its costs.
• Buyers
• Powerful buyers will force prices down or demand more value in the product, thus capturing more of the value for themselves.
• Suppliers
• Powerful suppliers will charge higher prices or insist on more favorable terms, lowering industry profitability.
• Substitutes
• Substitutes— products or services that meet the same basic need as the industry’s product in a different way— put a cap on industry profitability.
• Precisely because substitutes are not direct rivals, they often come from unexpected places. This makes substitutes difficult to anticipate or even to see once they appear.
• How do you assess the threat of a substitute? Look to the economics, specifically to whether the substitute offers an attractive price– performance trade-off relative to the industry’s product.
• The sweet spot isn’t always the lower-priced alternative. The Madrid– Barcelona high-speed train is a higher-value, higher-price substitute for flying.
• Switching costs play a significant role in substitution.
• New Entrants
• Entry barriers protect an industry from newcomers who would add new capacity.
• There are a number of different kinds of entry barriers. Start with the following questions to help you identify and assess them.
  • Does producing in larger volumes translate into lower unit costs? If there are economies of scale, at what volumes do they kick in? The numbers matter.
  • Will customers incur any switching costs in moving from one supplier to another?
  • Does the value to customers increase as more customers use a company’s product?(This is called a network effect.)
  • What is the price of admission for a company to enter the business? How large are the capital investments, and who might be willing and able to make them?
  • Do incumbents have advantages independent of size that new entrants can’t access? Examples include proprietary technology, well-established brands, prime locations, and access to distribution channels.
  • Does government policy restrict or prevent new entrants?
  • What kind of retaliation should a potential entrant expect should it choose to enter the industry? Is this industry known for making it tough for newcomers?
• Rivalry
• 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.
• How do you assess the intensity of rivalry? Porter notes that it is likely to be greatest if
  • The industry is composed of many competitors or if competitors are roughly equal in size and power.
  • Slow growth provokes battles over market share.
  • High exit barriers prevent companies from leaving the industry. This happens, for example, if companies have invested in specialized assets that can’t be sold. Excess capacity typically hurts an industry’s profitability.
  • Rivals are irrationally committed to the business; that is, financial performance is not the overriding goal.
• Price competition, Porter warns, is the most damaging form of rivalry. The more rivalry is based on price, the more you are engaged in competing to be the best. This is most likely when
  • It is hard to tell one rival’s offerings from another(the problem of competitor convergence we saw in chapter 1) and buyers have low switching costs.
  • Rivals have high fixed costs and low marginal costs, creating the pressure to drop prices because any new customer will”contribute to covering overhead.” Again, the essence of airline economics.
  • Capacity must be added in large increments, disrupting the industry’s supply– demand balance and leading to price cutting to fill capacity.
  • The product is perishable, an attribute that applies not only to fruit and fashion but also to a wide range of products and services that quickly become obsolete or lose their value. A hotel room, an airline seat, or a restaurant table that goes unfilled is”perishable.”
• Why Only Five Forces?
• The five forces framework applies in all industries for the simple reason that it encompasses relationships fundamental to all commerce.
• So let me underline the big idea here. Memorizing the five forces won’t make you a better business thinker; it will only help you to sound like one. It matters that you grasp the deeper point: there are a limited number of structural forces at work in every industry that systematically impact profitability in a predictable direction.
• Supply and Demand
• Everyone has learned at some point in their training about the importance of supply and demand in determining prices. In perfect markets, the adjustment is very sensitive: when supply rises, prices immediately drop to the new equilibrium. In perfect competition there are no profits because price is always driven down to the marginal cost of production. But in practice, very few markets are”perfect.” Porter’s five forces framework offers a way to think systematically about imperfect markets.
• 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. For example, growth might put suppliers in the driver’s seat, or, combined with low entry barriers, growth might attract new rivals. 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.
• Implications for Strategy
• The collective strength of the five forces matters because it affects prices, costs, and the investment required to compete.
• Typical Steps in Industry Analysis
  1. Define the relevant industry by both its product scope and geographic scope.
     • Porter offers this rule of thumb: where there are differences in more than one force, or where differences in any one force are large, you are likely dealing with distinct industries. Each will need its own strategy. Consider these examples:
       • Product scope. Is motor oil used in cars part of the same industry as motor oil used in trucks and stationary engines? The oil itself is similar. But automotive oil is marketed through consumer advertising, sold to fragmented customers through powerful channels, and produced locally to offset the high logistics costs of small packaging. Truck and power generation lubricants face a different industry structure— different customers and selling channels, different supply chains, and so on. From a strategy perspective, these are distinct industries.
       • Geographic scope. Is the cement business global or national? Recall the CEMEX example discussed earlier. Although some elements are the same, buyers are radically different in the United States and Mexico. The geographic scope is national, not global, and CEMEX will need a separate strategy for each market.
  2. Identify the players constituting each of the five forces and, where appropriate, segment them into groups.
  3. Assess the underlying drivers of each force. Which are strong? Which are weak? Why? The more rigorous your analysis, the more valuable your results.
  4. Step back and assess the overall industry structure. Which forces control profitability? Not all are equally important. Dig deeper into the most important forces in your industry. Are your results consistent with the industry’s level of profitability today and over the long term?
  5. Analyze recent and likely future changes for each force.
  6. How can you position yourself in relation to the five forces?
• Five forces analysis is used most often to determine the”attractiveness” of an industry, and this is certainly indispensible for companies and investors deciding whether to exit, enter, or invest in an industry. But using five forces analysis simply to declare that an industry is attractive or unattractive misses its full power. This use stops short of vital insights into the following questions: Why is current industry profitability what it is? What’s propping it up? What’s changing? How is profitability likely to shift? What limiting factors must be overcome to capture more of the value you create? In other words, a good five forces analysis allows you to see through the complexity of competition, and it opens the way to a host of possible actions you can take to improve performance. As unattractive as the PC business is for most of its players, Apple appears to have found a way to make money. By designing its own operating system, Apple has never been subject to Microsoft’s supplier power. By creating distinctive products, it has limited buyer power. Apple loyalists would rather pay more than switch.
• A second representative question is, Can you position your company where the forces are weakest?
• Competing to be unique, meeting different needs or serving different customers, lets Paccar run a different race. The forces affecting its prices and costs are more benign.“Strategy,” Porter writes, “can be viewed as building defenses against the competitive forces or finding a position in the industry where the forces are weakest.”
• Structure Is Dynamic
• Since, as I said in my introduction, many people get their Porter second hand, this is a point worth highlighting. To repeat, then, industry structure is dynamic, not static. When you do industry analysis, you are taking a snapshot of the industry at a point in time, but you are also assessing trends in the five forces.

Summary - The Five Forces: Competing for Profits

• The real point of competition is earning profits, not taking business away from your rivals. Business competition is about the struggle for profits, the tug-of-war over who gets to capture the value an industry creates.
• Companies compete for profits with their direct rivals, but also with their customers, their suppliers, potential new entrants, and substitutes.
• 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. A good strategy produces a P& L better than this industry average baseline.
• Using five forces analysis simply to declare that an industry is attractive or unattractive misses its full power as a tool. Because industry structure can”explain” the income statements and balance sheets of every company in the industry, insights gained from it should lead directly to decisions about where and how to compete.
• Industry structure is dynamic, not static. Five forces analysis can help anticipate and exploit structural change.

3. Competitive Advantage: The Value Chain and Your P&L

• For Porter, competitive advantage is not about trouncing rivals, it’s about creating superior value. Moreover, the term is both concrete and specific. 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.
• Right and Wrong Measures of Competitive Success
• What is the right goal for strategy? How should you measure competitive success? Porter is sometimes criticized for not paying enough attention to people, to management’s softer side. Yet he is adamant about the importance of setting the right goal, a view that couldn’t be more people-centric.
• In other words, organizations are supposed to use resources effectively. The financial measure that best captures this idea is return on invested capital(ROIC). ROIC weighs the profits a company generates versus all the funds invested in it, operating expenses and capital. Long-term ROIC tells you how well a company is using its resources. It is also, Porter points out, the only measure that matches the multidimensional nature of competition: creating value for customers, dealing with rivals, and using resources productively. ROIC integrates all three dimensions. Only if a company earns a good return can it satisfy customers in a sustainable way. Only if it uses resources effectively can it deal with rivals in a sustainable way.
• When Porter questions why so few companies are able to maintain successful strategies, he often points to flawed goals as the culprit:
• Porter’s solution to this problem requires some courage: the only way to know if you are achieving the ultimate goal of creating economic value is to be brutally honest about the true profits you’ve earned and all the capital you’ve committed to the business. Strategy, then, must start not only with the right goal, but also with a commitment to measure performance accurately and honestly. That’s a tall order, not because it’s technically challenging, but because the overwhelming tendency in organizations is to make results look as good as you possibly can.
• 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.
• If you have a competitive advantage, then, your profitability will be sustainably higher than the industry average(see figure 3-1). You will be able to command a higher relative price or to operate at a lower relative cost, or both.
• The right analytics: Why are some companies more profitable than others? A company’s performance has two sources:
  • Relative Price
  • Relative Cost
• Relative Price
• 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.
• In industrial markets, value to the customer(which Porter calls buyer value) can usually be quantified and described in economic terms.
• With consumers, buyer value may also have an”economic” component. For example, a consumer will pay more for prewashed salad in order to save time. But rarely do consumers actually figure out what they are paying for convenience, in the way a business customer would.
• A consumer’s WTP is more likely to have an emotional or intangible dimension, whether it is the trust engendered by an established brand or the status associated with owning the latest electronic gadget.
• The ability to command a higher price is the essence of differentiation, a term Porter uses in this somewhat idiosyncratic way.
• For Porter, then, differentiation refers to the ability to charge a higher relative price. My advice here: Don’t get hung up on the language, as long as you don’t get sloppy about the underlying distinction. Remind yourself that the goal of strategy is superior profitability and that one of its two possible components is relative price— that is, you are able to charge more than your rivals charge.
• Relative Cost
• The second component of superior profitability is relative cost— that is, you manage somehow to produce at lower cost than your rivals. To do so, you have to find more efficient ways to create, produce, deliver, sell, and support your product or service. Your cost advantage might come from lower operating costs or from using capital more efficiently(including working capital), or both.
• Sustainable cost advantages normally involve many parts of the company, not just one function or technology. Successful cost leaders multiply their cost advantages. They are not just”low-cost producers”— a commonly used phrase that implies that cost advantages come only from the production area. Typically, the culture of low cost permeates the entire company,
• Strategy choices aim to shift relative price or relative cost in a company’s favor.
• A good strategy would enable a nonprofit to produce more value for society(the analogue of higher price) for every dollar spent, or to produce as much value using fewer resources(the equivalent of lower cost).
• The Value Chain
• Activities are discrete economic functions or processes, such as managing a supply chain, operating a sales force, developing products, or delivering them to the customer. An activity is usually a mix of people, technology, fixed assets, sometimes working capital, and various types of information.
• Managers tend to think in terms of functional areas such as marketing or logistics because that is how their own expertise or organizational affiliation is defined. That’s too broad for strategy. To understand competitive advantage, it is critical to zoom in on activities, which are narrower than traditional functions. Alternatively, managers think in terms of skills, strengths, or competences(what the company is good at), but that’s too abstract and often too broad as well. To think clearly about actions you can take as a manager to impact prices and costs, you need to get down to the activity level where”what the company is good at” gets embodied in specific activities the company performs.
• The sequence of activities your company performs to design, produce, sell, deliver, and support its products is called the value chain. In turn, your value chain is part of a larger value system.
• In the 1920s, when cars were still rich men’s toys, General Motors and other automakers started their own consumer finance divisions to help customers buy cars on credit. Henry Ford, a man of strong convictions, believed that credit was immoral. He refused to follow GM’s lead. By 1930, 75 percent of cars and trucks were bought”on time,” and Ford’s once dominant market share had plummeted. In thinking about your value chain, then, it’s important to see how your activities have points of connection with those of your suppliers, channels, and customers. The way they perform activities affects your cost or your price, and vice versa.
• Why does it matter? The answer: The value chain is a powerful tool for disaggregating a company into its strategically relevant activities in order to focus on the sources of competitive advantage, that is, the specific activities that result in higher prices or lower costs
• Key Steps in Value Chain Analysis
  1. Start by laying out the industry value chain. Every established industry has one or more dominant approaches. These reflect the scope and sequence of activities that most of the companies in that industry perform, and this is as true for nonprofits as for any business.
• How far upstream or downstream do the industry’s activities extend? What are the key value-creating activities at each step in the chain? Compare the value chains of rivals in an industry to understand differences in prices and costs
• The key here is to lay out the major value-creating activities specific to your industry. If there are competing business models, lay out the value chain for each one. Then look for differences among rivals.
  1. Next, compare your value chain to the industry’s.
  2. Zero in on price drivers, those activities that have a high current or potential impact on differentiation.
     • Do you or could you create superior value for your customers by performing activities in a distinctive way or by performing activities that competitors don’t perform? Can you create that value without incurring commensurate costs? Buyer value can arise throughout the value chain.
  3. Zero in on cost drivers, paying special attention to activities that represent a large or growing percentage of costs.
• Do You Really Have a Competitive Advantage? First You Quantify, and Then You Disaggregate
  1. How does the long-term profitability in each of your businesses stack up against other companies in the economy?
  2. Now compare your performance to the average return in your industry, and do so over the last five to ten years.
  3. Next, keep digging to understand why the business is performing better or worse than the industry average.
• 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. Today it has become conventional wisdom.
• A second major consequence of value chain thinking is that it forces you to look beyond the boundaries of your own organization and its activities and to see that you are part of a larger value system involving other players.
• We now have a complete definition of competitive advantage: a difference in relative price or relative costs that arises because of differences in the activities being performed
• But those differences can take two distinct forms. A company can be better at performing the same configuration of activities, or it can choose a different configuration of activities. By now, of course, you recognize that the first approach is competition to be the best. And by now, we are in a better position to understand why this approach is unlikely to produce a competitive advantage.
• Porter uses the phrase operational effectiveness(OE) to refer to a company’s ability to perform similar activities better than rivals.
• Programs like these are compelling. Managers are rewarded for the tangible improvements they achieve when they implement the latest best practice inside their companies. That makes it all too easy to lose sight of the bigger picture of what’s happening outside their companies.
• But betting that you can achieve competitive advantage— a sustainable difference in price or cost— by performing the same activities as your rivals is a bet you will probably lose.

Part Two: What Is Strategy?

• In this section of chapters, we’ll cover 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

4. Creating Value: The Core

• The First Test: A Distinctive Value Proposition
• 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?
• Which Customers?
• Here’s what is essential: finding a unique way to serve your chosen segment profitably.
• Which Needs?
• Typically, value propositions based on needs appeal to a mix of customers who might defy traditional segmentation. Instead of belonging to a clear demographic category, the company’s customers will be defined by the common need or set of needs they share at a given time.
• Enterprise recognized that a sizeable minority of rentals, roughly 40 to 45 percent, occur in the renter’s home city. If your car is stolen, for example, or damaged in an accident, you’ll need a rental.
• What Relative Price?
• When Needs Are Overserved: Southwest. According to company legend, here’s how Southwest Airlines was born. Back in the late 1960s, “a couple of guys said, ‘Here’s an idea. Why don’t we start an airline that charges just a few bucks and has lots of flights every day instead of what the other guys are doing— charging a lot of bucks and having just a few flights each day?’” That, in a nutshell, is Southwest Airlines’ value proposition: very low prices coupled with very convenient service.
• In the early years, a shareholder asked CEO Herb Kelleher if Southwest couldn’t raise its prices by just a few dollars since its $15 price on the Dallas– San Antonio route was so much lower than Braniff’s$ 62 fare. Kelleher said no, our real competition is ground transportation, not other airlines.
• Southwest didn’t figure out every element of its value proposition on Day One. Companies rarely do. It learned by doing. Here’s a classic example of how that happens in practice. In 1971, one of the planes in Houston needed to go to Dallas for routine maintenance over the weekend. Then-CEO Lamar Muse didn’t want to fly the plane empty, figuring that some revenue was better than none. He offered seats on the Friday-night flight for $10, half off the standard$ 20 fare on that route. The flight sold out, providing some extra cash for the struggling start-up.
• 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. You’re competing to be the best.
• The Second Test: A Tailored Value Chain
• If you’re trying to describe a strategy, the value proposition is a natural place to begin.
• Insight into customers’ needs is important, but it’s not enough. The essence of strategy and competitive advantage lies in the activities, in choosing to perform activities differently or to perform different activities from those of rivals.
• Walmart, Progressive, and Edward Jones
• Many of Walmart’s markets were too small to support more than one large retailer. This was a powerful barrier to entry.
• For example, among drivers cited for drinking, those with children were least likely to reoffend; among motorcyclists, Harley owners aged forty-plus were likely to ride their bikes less often.
• To that end, Jones invests in conveniently located offices, and lots of them— in small towns, suburbs, and strip malls. Each office has just one financial advisor, a model unique in the industry.
• Aravind provides quality eye care at a price everyone can afford. That’s its value proposition. Its tailored value chain turns that promise into a strategy.
• Read more about this guy
• Note
• Each of the three reflects the most basic level of consistency that every effective strategy must have. Focus refers to the breadth or narrowness of the customers and needs a company serves. Differentiation allows a company to command a premium price. Cost leadership allows it to compete by offering a low relative price.
• “When you get down to the specific needs that are served by specific products,” he explains, “the possible choices/ combinations are far more complex. Generic strategies identified one dominant theme of a strategy, such as relative cost. But effective strategies integrate multiple themes in a unique way. Customers’ needs are rarely uni-dimensional and therefore a strategy to meet those needs won’t be uni-dimensional either. When a company makes choices about which customers and needs it will serve, and when it tailors its value chain to those choices, it is possible to be differentiated and low cost and focused at the same time, as Enterprise is. Or, like Southwest, you can be more convenient and lower cost— without getting stuck in the middle.”
• Choices in the value proposition that limit what a company will do are essential to strategy because they create the opportunity to tailor activities in a way that best delivers that 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. Only a value proposition that requires a tailored value chain to deliver it can serve as the basis for a robust strategy. This is the first line of defense against rivals.
• While not every single activity need be unique, robust strategies always involve a significant degree of tailoring. To establish a competitive advantage, a company must deliver its distinctive value through a distinctive value chain. It must perform different activities than rivals or perform similar activities in different ways. Thus the value proposition and the value chain— the two core dimensions of strategic choice— are inextricably linked. The value proposition focuses externally on the customer.
• Discovering New Positions: Where to Begin
• Discovering new positions is a creative act. What triggers the initial insight often varies from one person, and one organization, to the next. No cookbook or expert system can reliably churn out winning strategies. By definition, strategy is about creating something unique, making a set of choices that nobody else has made.

5. Trade-offs: The Linchpin

• If there is one important takeaway message, it is that strategy requires choice. Competitive advantage depends on making choices that are different from those of rivals, on making trade-offs. This is Porter’s third test. Trade-offs play such a critical role that it’s no exaggeration to call them strategy’s linchpin. They hold a strategy together as they contribute to both creating and sustaining competitive advantage.
• What Are Trade-offs?
• Trade-offs are the strategic equivalent of a fork in the road. If you take one path, you cannot simultaneously take the other.
• Robust strategies typically incorporate multiple trade-offs. The very best have trade-offs at almost every step in the value chain. Consider IKEA, the Swedish home furnishings giant. IKEA’s value proposition is to provide good design and function at a low price. Its target customer is what IKEA calls the person”with a thin wallet.” 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.
• Product design. IKEA’s furniture is modular and ready to assemble. The traditional retailer sells fully assembled pieces. That’s a critical either-or trade-off.
• Product variety.
• In turn, trade-offs that limit product complexity allow IKEA to source product in bulk from efficient third-party manufacturers that produce on a global scale.
• In-store service.
• IKEA is explicit about this trade-off. It tells its customers that in exchange for serving themselves, they will be rewarded with lower prices.
• Delivery and store design.
• IKEA chooses car-friendly locations(in the United States, never downtown) with ample free parking; it creates huge stores to display and stock every item(never small stores displaying only selected items).
• Porter is fond of saying that if you have a strategy, you should be able to link it directly to your P& L.
• Why Do Trade-offs Arise?
  • Porter highlights three. First, product features may be incompatible. That is, the product that best meets one set of needs performs poorly in addressing others.
  • Second, there may be trade-offs in activities themselves. In other words, the configuration of activities that best delivers one kind of value cannot equally well deliver another.
  • Another source of trade-offs is inconsistencies in image or reputation. Can you imagine, for example, the Italian sports car maker Ferrari introducing a minivan?
• Can you have high quality and low cost at the same time? Is quality free? Porter calls this a”dangerous half-truth.” The answer is”Yes, but.”
• Innovations such as new technologies and new management practices can result in both lower cost and improved performance. But only when such innovations change the game— or when a company is lagging in efficiency to begin with— is it true that quality is free.
• When managers focus on execution, on making sure that they are”best practice” when it comes to generic activities, then eliminating trade-offs can be a good thing. When it comes to strategy, however, trade-offs are essential in making what you do unique. Finding trade-offs— IKEA’s insight about the value of flat packs, for example— is essential to creating strategy. Maintaining and steepening trade-offs, making them even sharper, is essential to sustaining strategy.
• McDonald’s learned about trade-offs the hard way. It couldn’t copy Burger King’s strategy without messing up its own. Porter calls what McDonald’s tried to do straddling, and it is the most common form of competitive imitation. The straddler, as the word implies, tries to match the benefits of the successful position while at the same time maintaining its existing position.
• Some analysts were quick to proclaim Lowe’s”the winner.” For Porter, this was precisely the kind of destructive, zero-sum thinking that gets in the way of companies when they try to compete on uniqueness.
• Choosing What Not to Do
• But it is just as important to decide which needs you will not serve, and which products, features, or services you won’t offer. And then comes the hard part— sticking to those decisions. Companies tend over time to add functions and features to their products, hoping this will broaden their customer base and increase sales. The”more is better” psychology is hard to resist.
• When you try to offer something for everyone, you tend to relax the trade-offs that underpin your competitive advantage. Wherever you find an organization that has sustained its competitive advantage over a period of many years, you can be sure that company has defended its key trade-offs against numerous onslaughts.
• Porter calls one of the great paradoxes about trade-offs in competition. Executives often resist making trade-offs for fear they will lose some customers. The irony is that unless they make trade-offs and deliberately choose not to serve all customers and needs, then they are unlikely to do a good job of serving any customers and needs.
• The role of trade-offs in strategy is deliberately to make some customers unhappy.
• The Pen Pal complained about almost every choice Southwest makes. After sending numerous polite responses to her many letters, the customer relations people had run out of ideas. They asked Herb if he would reply. It didn’t take him long to write the following: “Dear Mrs. Crabapple, We will miss you. Love, Herb.”
• The notion that the customer is always right is one of those half-truths that can lead to mediocre performance. Trade-offs explain why it is not true that you should give every customer what he or she wants.

6. Fit: The Amplifier

• The fallacy here is that good strategies don’t rely on just one thing, on making one choice. Nor do they typically result from even a series of independent choices. Good strategies depend on the connection among many things, on making interdependent choices.
• Fit amplifies the competitive advantage of a strategy by lowering costs or raising customer value(and price). Fit also makes a strategy more sustainable by raising barriers to imitation.
• Fit means that the value or cost of one activity is affected by the way other activities are performed.
• The first kind of fit is basic consistency, where each activity is aligned with the company’s value proposition and each contributes incrementally to its dominant themes. Think about the speed that is critical to Zara’s success.
• A second type of fit occurs when activities complement or reinforce each other. This is real synergy, where the value of each activity is raised by the other.
• Porter’s third type of fit is substitution. Here performing one activity makes it possible to eliminate another.
• 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. You can start by identifying the core elements of the value proposition. For IKEA, I would highlight three: distinctive design, low prices, and immediate use. You then identify the most salient activities performed in the business, those most responsible for creating customer value or those that generate significant cost. Try to list the unique activity choices at each step. This makes contrasts between the company and its competitors more obvious.
• A common mistake in strategy is to choose the same core competences as everyone else in your industry.
• Instead of trying to determine which activities are core, Porter asks a different question: Which activities are generic and which are tailored? Generic activities— those that cannot be meaningfully tailored to a company’s position— can be safely outsourced to more efficient external suppliers.
• Basic consistency may be readily discerned by rivals, but the more a company’s positioning rests on complex fit, the harder it is for rivals to know exactly what it is they are trying to copy. Unless you’re an insider, it’s very difficult to untangle what’s going on.

7. Continuity: The Enabler

• WE COME NOW TO the fifth and final test of strategy: continuity over time. To recap: the first two tests— a unique value proposition and a tailored value chain— are the core of a strategy. Trade-offs, the third test, are the economic linchpin. They make differences in price and cost possible and sustainable. Fit, the fourth test, is an amplifier, enhancing the cost and price differences that are the essence of competitive advantage, and making it even harder for rivals to copy the strategy. Continuity is the enabler. All the other elements of strategy— tailoring, trade-offs, fit— take time to develop. Without continuity, organizations are unlikely to develop competitive advantage in the first place.
• Allow me one cooking metaphor: strategy isn’t a stir fry; it’s a stew. It takes time for the flavors and textures to develop. Over time, as all of a company’s constituents— internal and external— come to a deeper understanding of what a company can offer them, or what they can offer to it, a whole raft of activities become better tailored to the strategy and better aligned with each other.
• Continuity reinforces a company’s identity— it builds a company’s brand, its reputation, and its customer relationships.
• A good strategy, consistently maintained over time through repeated interactions with customers, is what gives power to a brand.
• Continuity helps suppliers, channels, and other outside parties to contribute to a company’s competitive advantage.
• Continuity fosters improvements in individual activities and fit across activities; it allows an organization to build unique capabilities and skills tailored to its strategy.
• 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’s delivered.
• Great strategies are rarely, if ever, built on a particularly detailed or concrete prediction of the future.
• You need only a very broad sense of which customers and needs are going to be relatively robust five or ten years from now.
• When Does Strategy Need to Change?
  • First, as customer needs change, a company’s core value proposition may simply become obsolete.
  • Second, innovation of all sorts can serve to invalidate the essential trade-offs on which a strategy relies.
  • Third, a technological or managerial breakthrough can completely trump a company’s existing value proposition.
• To determine whether a technology is truly disruptive, ask whether it can be integrated into the company’s existing value chain or customized in a way that enhances the company’s existing activities. In practice, Porter argues, truly disruptive technologies are quite rare.
• Says Mulally, “ ‘ That is what strategy is all about. It’s about a point of view about the future and then making decisions based on that. The worst thing you can do is not have a point of view, and not make decisions.’ “ Porter couldn’t have said it better himself.
• When you substitute flexibility for strategy, your organization never stands for anything or becomes good at anything.
• What Must Change?
• First, you must stay on the frontier of operational effectiveness. If you don’t, strategy won’t matter. You must continuously assimilate best practices that do not conflict with your strategy or the trade-offs essential to it. Failure to keep up on this dimension will result in cost penalties that can swamp your other advantages.
• Second, you must change whenever there are ways to extend your value proposition or better ways to deliver it.
• When Porter writes about strategy, he chooses companies with fully developed, rich strategies, companies like Southwest or IKEA. If there were a Nobel Prize for business strategy, these companies would win it. These great exemplars pass all the tests of strategy with flying colors. They have achieved what most managers can only dream of: stellar performance over several decades(figure 7-2). Porter examines those companies, after the fact, and asks, What explains their success? The answer is always the same: each was able to create a complex business system elegantly configured to produce a certain kind of value in a specific industry context. Let me underscore that these organizations have spent decades honing these systems, these intricate complex wholes. This is why continuity over time is one of Porter’s five tests, and why I call it the enabler.
• So what does Porter say about how to strike the right balance between designing a strategy analytically and experimenting until one emerges? You might assume that Porter would come down 100 percent on the”design” side of the argument. Not so. Good analysis is essential, but it’s a mistake, he argues, to think that a strategy should be fully defined in its entirety before the fact. There are simply too many variables and too much uncertainty to anticipate everything.
• Continuity gives an organization the time it needs to deepen its understanding of the strategy. Sticking with a strategy, in other words, allows a company to more fully understand the value it creates and to become really good at it.
• IKEA’s founder, Ingvar Kamprad, started his company in 1943, but he didn’t actually open a store until 1958, and it wasn’t until the mid-1960s that IKEA tested its signature self-service store design.
• At the opposite extreme, Porter warns against thinking that an organization can simply stumble its way into a strategy by encouraging unconnected experimentation in all of its units. Strategy is about the whole, not the parts. There must be a stable core to begin with, or at least a grounded hypothesis about how the company is going to create and capture value.
• Often, strategies begin with two or three essential choices. Over time, as the strategy becomes clearer, additional choices complement and extend the original ones.
• Porter’s key point is this: rarely, if ever, is it possible to figure out everything that will eventually matter at the very start. Change, then, is inevitable, and the capacity to change is critically important. But continuity of direction makes effective change more likely. There is no denying that dumb luck has played a role in some extraordinary business successes. But, as Porter likes to ask, would you be eager to invest in someone whose”strategy” is to rely on dumb luck? You may not be able to analyze your way to spectacular success— creativity and serendipity play a role. But armed with an understanding of strategy essentials, you are more likely— far more likely— to make better decisions along the way.
• Paradoxically, continuity of strategy actually improves an organization’s ability to adapt to changes in the environment and to innovate.
• Porter argues that the deliberate and explicit setting of strategy is more important than ever during periods of change and uncertainty. But it’s no paradox at all when you stop to think that strategy offers a clear direction, allowing managers to tune out the many distractions around them.
• Ten Practical Implications
  1. Vying to be the best is an intuitive but self-destructive approach to competition.
  2. There is no honor in size or growth if those are profitless. Competition is about profits, not market share.
  3. 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.
  4. A distinctive value proposition is essential for strategy. But strategy is more than marketing. If your value proposition doesn’t require a specifically tailored value chain to deliver it, it will have no strategic relevance.
  5. 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.
  6. 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.
  7. Don’t overestimate or underestimate the importance of good execution. It’s unlikely to be a source of a sustainable advantage, but without it even the most brilliant strategy will fail to produce superior performance.
  8. Good strategies depend on many choices, not one, and on the connections among them. A core competence alone will rarely produce a sustainable competitive advantage.
  9. 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.
  10. Committing to a strategy does not require heroic predictions about the future. Making that commitment actually improves your ability to innovate and to adapt to turbulence.

FAQs: An Interview with Michael Porter

• Common Mistakes and Obstacles
• 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. It’s natural for strategy to arise from a focus on customers and their needs. So in many companies, strategy is built around the value proposition, which is the demand side of the equation. But a robust strategy requires a tailored value chain— it’s about the supply side as well, the unique configuration of activities that delivers value. Strategy links choices on the demand side with the unique choices about the value chain(the supply side). You can’t have competitive advantage without both.
• Another mistake is to overestimate strengths. There’s an inward-looking bias in many organizations. You might perceive customer service as a strong area. So that becomes the”strength” on which you attempt to build a strategy. But a real strength for strategy purposes has to be something the company can do better than any of its rivals. And”better” because you are performing different activities than they perform, because you’ve chosen a different configuration than they have.
• Another common mistake is getting the definition of the business wrong, or getting the geographic scope wrong.
• His famous example was railroads that failed to see that they were in the transportation business, and so they missed the threat posed by trucks and airfreight. The problem with defining the business as transportation, however, is that railroads are clearly a distinct industry with distinct economics and a separate value chain. Any sound strategy in railroads must take these differences into account. Defining the industry as transportation can be dangerous if it leads managers to conclude that they need to acquire an airfreight company so they can compete in multiple forms of transportation.
• Reflecting on my experience, however, I’d have to say that the worst mistake— and the most common one— is not having a strategy at all. Most executives think they have a strategy when they really don’t, at least not a strategy that meets any kind of rigorous, economically grounded definition.
• There are so many barriers that distract, deter, and divert managers from making clear strategic choices. Some of the most significant barriers come from the many hidden biases embedded in internal systems, organizational structures, and decision-making processes. It’s often hard, for example, to get the kind of cost information you need to think strategically. Or the company’s incentive system rewards the wrong things. Or human nature makes it really hard to make trade-offs, or to stick with them. The need for trade-offs is a huge barrier.
• Capital markets have become toxic for strategy. The single-minded pursuit of shareholder value… has been enormously destructive for strategy and value creation.
• But the problem for strategy is that the same metrics are applied to all companies in the industry. One of the important lessons about strategy is that if you’re pursuing a different positioning, then different metrics will be relevant. And if you force everybody to show progress on the same metrics, you encourage convergence and undermine strategic uniqueness.
• The pressure to grow is among the greatest threats to strategy.
• Here are some thoughts about how to grow profitably without destroying your strategy. First, never copy. Companies always are confronted with opportunities for new products, new services, or moving into adjacent customer groups. How should you think about that? If your competitor has a good idea, learn from it, think about what that innovation accomplishes, but don’t just copy it. Figure out how the idea could be adapted and modified in order to reinforce your strategy. Is it relevant to the needs you’re trying to serve? Could it be used to reinforce what makes you unique? You don’t have to jump on every trend. But if the trend is relevant, tailor it to your strategy.
• Second, deepen your strategic position, don’t broaden it. A company can usually grow faster— and far more profitably— by better penetrating needs and customers where it is distinctive than by slugging it out in potentially higher growth arenas in which the company lacks uniqueness.
• The common mistake is to settle for 50 percent of your target segment when 80 percent is achievable. You can shoot for true leadership when the customer target is properly defined not as the whole industry, but as the set of customers and needs that your strategy serves best.
• 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.
• But you have to be really focused, because the tendency in geographic expansion is to get too caught up in the differences present in the new market. Find the part of the new market that responds to what you do rather than try to adapt to all the differences.
• Another key characteristic of successful internationalization is that you’ve got to get direct contact with the customer.
• Magretta: And what do you do if none of those approaches to growth are feasible? Porter: That’s an important question that too few managers are willing to face. Sometimes, at the end of the day, the answer is that there are few opportunities to grow rapidly with your strategy and do it profitably. You’ve got a strong position in your space, and no good way to expand it significantly. Here, the huge mistake is to deny that reality and to try to turn lead into gold. Instead, you should simply make a good ROIC, pay good dividends or otherwise return capital, and enjoy creating value and wealth. I think many more companies should pay higher dividends rather than take enormous risks trying to grow beyond the capacity of their strategy and their industry structure.
• A disruptive technology is not any new technology. Many new technologies are not disruptive. Nor is it any big technological leap, because many big leaps are not disruptive. A disruptive technology is one that invalidates value chain configurations and product configurations in ways that allow one company to leap ahead of another and/ or make it hard for incumbents to match or respond because of the existing assets they have. So a disruptive technology is one that would invalidate important competitive advantages. The Internet offers a classic case.
• Two questions will tell you whether you’re dealing with a disruptive technology or not. First, to what extent does it invalidate important traditional advantages? Second, to what extent can incumbents embrace the technology without major negative consequences for their business? If you stop and ask those questions, you’ll see that true disruptions are not so common. If you look over a decade, for example, at the hundreds of industries that make up the economy, I would guess that less than 5 to 10 percent would be affected by a disruptive technology.
• 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?
• 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. Strategy goes an important step further. It looks at relative prices and relative costs, and their sustainability. That is, how your revenues and costs stack up against your rivals’. And then it links those to the activities in your value chain, and ultimately to your income statement and your balance sheet.
• Porter: Strategy is relevant for any organization at any point in its trajectory. How to develop and sustain a competitive advantage is the core question that every organization has to answer if it’s to be successful and to prosper. In emerging industries there’s a lot of experimentation.
• Strategy is about the whole enterprise, not the individual pieces. That’s a foundational principle of good strategy. There’s no such thing as a good marketing strategy. There’s only a good marketing strategy in the context of the overall strategy.
• Magretta: How do you get everybody in the organization on the same page? Porter: Communicating the strategy is really 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.
• How do you communicate it? Well, you’ve got to find a concise and memorable way to explain your strategy. Really good leaders crystallize the value proposition into something relatively simple.
• I also believe that you should communicate your strategy to your customers, to your suppliers, to your channels, and to the capital markets.