SUMMARY | Understanding Michael Porter

by Joan Magretta

Question: What makes some companies more profitable than others?

Chapter 1: Competition

Misconception: competition is about being the best.

Fact: companies should try to be unique.

Comparison to war or sport is bad because multiple winners can coexist in business. Walmart and Target can both be winners, same for McDonalds and In-n-Out.

Competitive convergence: competitors become more alike when trying to be the best — bad.

Chapter 2: The Five Forces

Point of competition is not about beating rivals, but to earn profits.

Competition is about who gets to keep the value an industry creates.

Companies compete for profits with their rivals, but also their customers, suppliers, new entrants and substitutes.

Profit = Price - Cost

Industry structure is defined by the five forces:

1. Buyers: Powerful buyers will force prices down or demand more value in the product, thus getting more value themselves.

2. Suppliers: Powerful suppliers will charge higher prices or insist on more favorable terms, lowering industry profitability.

3. Substitutes: Substitutes — products or services that meet same basic need as industry’s product in a different way, puts cap on industry profitability.

4. New entrants: Entry barriers protect industry from newcomers who would add new capacity.

5. 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. Price competition is most damaging form of rivalry.

Industry structure is dynamic, not static. Five forces analysis can help anticipate and exploit structural change.

Chapter 3: Competitive Advantage

Competitive advantage: superior performance resulting from sustainably higher prices, lower costs, or both.

Relative price: a company can only sustain a premium price if it offers something both unique and valuable.

Relative cost: to reduce relative costs, you need to find efficient ways to create, produce, deliver, sell and support your product/service.

Differentiation: the ability to charge a higher relative price.

Strategy choices aim to improve relative price or relative cost.

Measures of performance:

• ROIC is the best measure of how well a company uses its resources.
• ROS ignores capital invested.
• Growth and market share fail to account for capital required. “Companies could achieve rapid growth by cutting their prices in half.”
• Shareholder value (stock price) really bad goal.

The sequence of activities your company performs to design, produce, sell, deliver, and support its products is called the value chain.

Activities: discrete economic functions or processes, such as managing a supply chain, operating a sales force, developing products etc.

1. Look at industry value chain

2. Compare your value chain to industry

3. Zero in on price drivers (activities with high current or potential impact on differentiation.

4. Zero in on cost drivers (pay special attention to activities that are a large or growing percentage of costs)

Part 2: What is strategy? (quick recap)

Competitive advantage: create value for customers and yourself, because your positioning shields you from the profit-eroding five forces. More simply put: you perform better by being different.

Strategy is the antidote to competition.

Five tests of strategy (chapters 4 - 7):

Chapter 4: Creating value

A distinctive value proposition (demand side of the business).

• Which customers to serve?
• Which needs to meet?
• What relative price will provide value for customers and profitability for company?

Test 1: Is your value proposition different from you rivals?

A tailored value chain (performing activities differently, or performing different activities)

Only way to tailor activities: choices in the value proposition that limit what a company does.

Test 2: Is your value chain tailored to your value proposition?

Chapter 5: Trade-offs

Strategy is about making choices. Competitive advantage depends on making choices that are different from those of rivals. The essence of strategy is choosing what not to do.

Trade-off: incompatible choices. If you choose one, you cannot choose the other.

Trade-offs are choices that make strategy sustainable because they are hard to match.

Test 3: Have you made different trade-offs than your rivals?

Chapter 6: Fit

Fit: how the activities in the value chain relate to one another. Fit amplifies the competitive advantage of a strategy (by lowering costs and raising customer value and price).

Fit means that the value or cost of one activity is affected by the way other activities are performed.

Fit locks out imitators by creating a chain that is as strong as its strongest link.

Three types of fit:

1. Basic consistency (whole more than sum of its parts)
2. Real synergy (complementary/reinforcing activities)
3. Substitution (performing one activity enable to eliminate another)

Core competences: critical resources, core capabilities, key success factors.

Common mistake in strategy: choosing the same core competences as everyone else in the industry.

Activity system map: chart significant activities and their relationship to the value proposition and each other. Densely connected = good strategy.

Keep the core, outsource the rest? Instead of asking what are the core competencies, ask which activities are generic and which are tailored.

Test 4: Are your activities enhanced by each other?

Chapter 7: Continuity

Continuity at the core of the strategy enables the company to get good at its activities, and foster tailoring, trade-offs and fit.

Continuity helps suppliers, channels and other outside parties to contribute to company’s competitive advantage.

Continuity of strategy does not mean that an organization should stand still. Paradoxically, continuity of strategy actually improves an organization’s ability to adapt to changes and to innovate.

Strategies are not built on a detailed prediction of the future.

When strategy needs to change:

1. Customer needs change (value proposition becomes obsolete)
2. Innovation invalidating essential trade-offs strategy relies on
3. Technological/managerial breakthrough

The deliberate and explicit setting of strategy is more important than ever during periods of change and uncertainty.

Test 5: Is there enough stability in the core of the strategy to allow the organization to get good at what it does?

Epilogue

Practical implications:

1. Trying to be the best is intuitive, but self-destructive.
2. Competition is about profit, not market share. Size and growth are pointless if profitless.
3. Competitive advantage is about creating unique value for customers, not beating rivals. If you have competitive advantage, it will show up in your P&L.
4. Distinctive value proposition is essential for strategy. But if it doesn’t require a specifically tailored value chain to deliver, it has no strategic relevance.
5. Sign of a good strategy is that it deliberately makes some customers unhappy. (making choices on what not to do, trade-offs in order to specialize)
6. Strategy needs to specify what the company will not do. Making trade-offs makes competitive advantage possible and sustainable.
7. Good execution is important. It is unlikely the source of sustainable advantage, but without it any strategy will fail.
8. Good strategy depends on many choices and the connections between them. A core competence alone will rarely sustain a competitive advantage.
9. Continuity is important. Flexibility in times of uncertainty sounds good, but it means the company will never become good at anything. Too much change is just as bad as too little.
10. Do not need to predict the future to commit to a strategy. Making commitments actually improves ability to innovate and adapt.

FAQs

Common mistakes:

• Competing to be the best
• Confusing marketing with strategy
• Overestimating strengths
• Wrong definition of business or geographic scope
• Thinking they have a strategy when they really don’t
• Strategic planning becoming a time-consuming ritual that doesn’t support strategic thinking
• Capital markets, focus on shareholder value is bad for strategy and value creation
• Pressure to grow is bad for strategy

Advice:

• Concentrate on deepening and extending strategic position, rather than broadening