by Michael E. Porter, Micheal Porter
Chapter 1: Competitive Strategy: The Core Concepts
Competition is at the core of the success or failure of firms. Competition determines the appropriateness of a firm's activities that can contribute to its performance, such as innovations, a cohesive culture, or good implementation. Competitive strategy is the search for a favorable competitive position in an industry, the fundamental arena in which competition occurs. Competitive strategy aims to establish a profitable and sustainable position against the forces that determine industry competition.
Two central questions underlie the choice of competitive strategy. The first is the attractiveness of industries for long-term profitability and the factors that determine it. Not all industries offer equal opportunities for sustained profitability, and the inherent profitability of its industry is one essential ingredient in determining the profitability of a firm. The second central question in competitive strategy is the determinants of relative competitive position within an industry. In most industries, some firms are much more profitable than others, regardless of what the average profitability of the industry may be.
Neither question is sufficient by itself to guide the choice of competitive strategy. A firm in a very attractive industry may still not earn attractive profits if it has chosen a poor competitive position. Conversely, a firm in an excellent competitive position may be in such a poor industry that it is not very profitable, and further efforts to enhance its position will be of little benefit. Both questions are dynamic; industry attractiveness and competitive position change. Industries become more or less attractive over time, and competitive position reflects an unending battle among competitors. Even long periods of stability can be abruptly ended by competitive moves.
Both industry attractiveness and competitive position can be shaped by a firm, and this is what makes the choice of competitive strategy both challenging and exciting. While industry attractiveness is partly a reflection of factors over which a firm has little influence, competitive strategy has considerable power to make an industry more or less attractive. At the same time, a firm can clearly improve or erode its position within an industry through its choice of strategy. Competitive strategy, then, not only responds to the environment but also attempts to shape that environment in a firm's favor.
These two central questions in competitive strategy have been at the core of my research. My book Competitive Strategy: Techniques for Analyzing Industries and Competitors presents an analytical framework for understanding industries and competitors, and formulating an overall competitive strategy. It describes the five competitive forces that determine the attractiveness of an industry and their underlying causes, as well as how these forces change over time and can be influenced through strategy. It identifies three broad generic strategies for achieving competitive advantage. It also shows how to analyze competitors and to predict and influence their behavior, and how to map competitors into strategic groups and assess the most attractive positions in an industry. It then goes on to apply the framework to a range of important types of industry environments that I term structural settings, including fragmented industries, emerging industries, industries undergoing a transition to maturity, declining industries, and global industries. Finally, the book examines the important strategic decisions that occur in the context of an industry, including vertical integration, capacity expansion, and entry.
This book takes the framework in Competitive Strategy as a starting point. The central theme of this book is how a firm can actually create and sustain a competitive advantage in its industry -- how it can implement the broad generic strategies. My aim is to build a bridge between strategy and implementation, rather than treat these two subjects independently or consider implementation scarcely at all as has been characteristic of much previous research in the field.
Competitive advantage grows fundamentally out of value a firm is able to create for its buyers that exceeds the firm's cost of creating it. Value is what buyers are willing to pay, and superior value stems from offering lower prices than competitors for equivalent benefits or providing unique benefits that more than offset a higher price. There are two basic types of competitive advantage: cost leadership and differentiation. This book describes how a firm can gain a cost advantage or how it can differentiate itself. It describes how the choice of competitive scope, or the range of a firm's activities, can play a powerful role in determining competitive advantage. Finally, it translates these concepts, combined with those in my earlier book, into overall implications for offensive and defensive competitive strategy, including the role of uncertainty in influencing strategic choices. This book considers not only competitive strategy in an individual industry but also corporate strategy for the diversified firm. Competitive advantage in one industry can be strongly enhanced by interrelationships with business units competing in related industries, if these interrelationships can actually be achieved. Interrelationships among business units are the principal means by which a diversified firm creates value, and thus provide the underpinnings for corporate strategy. I will describe how interrelationships among business units can be identified and translated into a corporate strategy, as well as how interrelationships can be achieved in practice despite the organizational impediments to doing so that are present in many diversified firms.
Though the emphases of this book and my earlier book are different, they are strongly complementary. The emphasis of Competitive Strategy is on industry structure and competitor analysis in a variety of industry environments, though it contains many implications for competitive advantage. This book begins by assuming an understanding of industry structure and competitor behavior, and is preoccupied with how to translate that understanding into a competitive advantage. Actions to create competitive advantage often have important consequences for industry structure and competitive reaction, however, and thus I will return to these subjects frequently.
This book can be read independently of Competitive Strategy, but its power to aid practitioners in formulating strategy is diminished if the reader is not familiar with the core concepts presented in the earlier book. In this chapter, I will describe and elaborate on some of those concepts. The discussion of the core concepts will also provide a good means of introducing the concepts and techniques in this book. In the process, I will address some of the most important questions that arise in applying the core concepts in practice. Thus even readers familiar with my earlier book may find the review of interest.
The Structural Analysis of Industries
The first fundamental determinant of a firm's profitability is industry attractiveness. Competitive strategy must grow out of a sophisticated understanding of the rules of competition that determine an industry's attractiveness. The ultimate aim of competitive strategy is to cope with and, ideally, to change those rules in the firm's favor. In any industry, whether it is domestic or international or produces a product or a service, the rules of competition are embodied in five competitive forces: the entry of new competitors, the threat of substitutes, the bargaining power of buyers, the bargaining power of suppliers, and the rivalry among the existing competitors.
The collective strength of these five competitive forces determines the ability of firms in an industry to earn, on average, rates of return on investment in excess of the cost of capital. The strength of the five forces varies from industry to industry, and can change as an industry evolves. The result is that all industries are not alike from the standpoint of inherent profitability. In industries where the five forces are favorable, such as pharmaceuticals, soft drinks, and data base publishing, many competitors earn attractive returns. But in industries where pressure from one or more of the forces is intense, such as rubber, steel, and video games, few firms command attractive returns despite the best efforts of management. Industry profitability is not a function of what the product looks like or whether it embodies high or low technology, but of industry structure. Some very mundane industries such as postage meters and grain trading are extremely profitable, while some more glamorous, high-technology industries such as personal computers and cable television are not profitable for many participants.
The five forces determine industry profitability because they influence the prices, costs, and required investment of firms in an industry -- the elements of return on investment. Buyer power influences the prices that firms can charge, for example, as does the threat of substitution. The power of buyers can also influence cost and investment, because powerful buyers demand costly service. The bargaining power of suppliers determines the costs of raw materials and other inputs. The intensity of rivalry influences prices as well as the costs of competing in areas such as plant, product development, advertising, and sales force. The threat of entry places a limit on prices, and shapes the investment required to deter entrants.
The strength of each of the five competitive forces is a function of industry structure, or the underlying economic and technical characteristics of an industry. Industry structure is relatively stable, but can change over time as an industry evolves. Structural change shifts the overall and relative strength of the competitive forces, and can thus positively or negatively influence industry profitability. The industry trends that are the most important for strategy are those that affect industry structure.
If the five competitive forces and their structural determinants were solely a function of intrinsic industry characteristics, then competitive strategy would rest heavily on picking the right industry and understanding the five forces better than competitors. But while these are surely important tasks for any firm, and are the essence of competitive strategy in some industries, a firm is usually not a prisoner of its industry's structure. Firms, through their strategies, can influence the five forces. If a firm can shape structure, it can fundamentally change an industry's attractiveness for better or for worse. Many successful strategies have shifted the rules of competition in this way.
In any particular industry, not all of the five forces will be equally important and the particular structural factors that are important will differ. Every industry is unique and has its own unique structure. The five-forces framework allows a firm to see through the complexity and pinpoint those factors that are critical to competition in its industry, as well as to identify those strategic innovations that would most improve the industry's -- and its own -- profitability. The five-forces framework does not eliminate the need for creativity in finding new ways of competing in an industry. Instead, it directs managers' creative energies toward those phpects of industry structure that are most important to long-run profitability. The framework aims, in the process, to raise the odds of discovering a desirable strategic innovation.
Strategies that change industry structure can be a double-edged sword, because a firm can destroy industry structure and profitability as readily as it can improve it. A new product design that undercuts entry barriers or increases the volatility of rivalry, for example, may undermine the long-run profitability of an industry, though the initiator may enjoy higher profits temporarily. Or a sustained period of price cutting can undermine differentiation. In the tobacco industry, for example, generic cigarettes are a potentially serious threat to industry structure. Generics may enhance the price sensitivity of buyers, trigger price competition, and erode the high advertising barriers that have kept out new entrants. Joint ventures entered into by major aluminum producers to spread risk and lower capital cost may have similarly undermined industry structure. The majors invited a number of potentially dangerous new competitors into the industry and helped them overcome the significant entry barriers to doing so. Joint ventures also can raise exit barriers because all the participants in a plant must agree before it can be closed down.
Often firms make strategic choices without considering the long-term consequences for industry structure. They see a gain in their competitive position if a move is successful, but they fail to anticipate the consequences of competitive reaction. If imitation of a move by major competitors has the effect of wrecking industry structure, then everyone is worse off. Such industry "destroyers" are usually second-tier firms that are searching for ways to overcome major competitive disadvantages, firms that have encountered serious problems and are desperately seeking solutions, or "dumb" competitors that do not know their costs or have unrealistic assumptions about the future. In the tobacco industry, for example, the Liggett Group (a distant follower) has encouraged the trend toward generics.
The ability of firms to shape industry structure places a particular burden on industry leaders. Leaders' actions can have a disproportionate impact on structure, because of their size and influence over buyers, suppliers, and other competitors. At the same time, leaders' large market shares guarantee that anything that changes overall industry structure will affect them as well. A leader, then, must constantly balance its own competitive position against the health of the industry as a whole. Often leaders are better off taking actions to improve or protect industry structure rather than seeking greater competitive advantage for themselves. Such industry leaders as Coca-Cola and Campbell's Soup appear to have followed this principle.
Industry Structure and Buyer Needs
It has often been said that satisfying buyer needs is at the core of success in business endeavor. How does this relate to the concept of industry structural analysis? Satisfying buyer needs is indeed a prerequisite to the viability of an industry and the firms within it. Buyers must be willing to pay a price for a product that exceeds its cost of production, or an industry will not survive in the long run. Chapter 4 will describe in detail how a firm can differentiate itself by satisfying buyer needs better than its competitors.
Satisfying buyer needs may be a prerequisite for industry profitability, but in itself is not sufficient. The crucial question in determining profitability is whether firms can capture the value they create for buyers, or whether this value is competed away to others. Industry structure determines who captures the value. The threat of entry determines the likelihood that new firms will enter an industry and compete away the value, either passing it on to buyers in the form of lower prices or dissipating it by raising the costs of competing. The power of buyers determines the extent to which they retain most of the value created for themselves, leaving firms in an industry only modest returns. The threat of substitutes determines the extent to which some other product can meet the same buyer needs, and thus places a ceiling on the amount a buyer is willing to pay for an industry's product. The power of suppliers determines the extent to which value created for buyers will be appropriated by suppliers rather than by firms in an industry. Finally, the intensity of rivalry acts similarly to the threat of entry. It determines the extent to which firms already in an industry will compete away the value they create for buyers among themselves, passing it on to buyers in lower prices or dissipating it in higher costs of competing.
Industry structure, then, determines who keeps what proportion of the value a product creates for buyers. If an industry's product does not create much value for its buyers, there is little value to be captured by firms regardless of the other elements of structure. If the product creates a lot of value, structure becomes crucial. In some industries such as automobiles and heavy trucks, firms create enormous value for their buyers but, on average, capture very little of it for themselves through profits. In other industries such as bond rating services, medical equipment, and oil field services and equipment, firms also create high value for their buyers but have historically captured a good proportion of it. In oil field services and equipment, for example, many products can significantly reduce the cost of drilling. Because industry structure has been favorable, many firms in the oil field service and equipment sector have been able to retain a share of these savings in the form of high returns. Recently, however, the structural attractiveness of many industries in the oil field services and equipment sector has eroded as a result of falling demand, new entrants, eroding product differentiation, and greater buyer price sensitivity. Despite the fact that products offered still create enormous value for the buyer, both firm and industry profits have fallen significantly.
Industry Structure and the Supply/Demand Balance
Another commonly held view about industry profitability is that profits are a function of the balance between supply and demand. If demand is greater than supply, this leads to high profitability. Yet, the long-term supply/demand balance is strongly influenced by industry structure, as are the consequences of a supply/demand imbalance for profitability. Hence, even though short-term fluctuations in supply and demand can affect short-term profitability, industry structure underlies long-term profitability.
Supply and demand change constantly, adjusting to each other. Industry structure determines how rapidly competitors add new supply. The height of entry barriers underpins the likelihood that new entrants will enter an industry and bid down prices. The intensity of rivalry plays a major role in determining whether existing firms will expand capacity aggressively or choose to maintain profitability. Industry structure also determines how rapidly competitors will retire excess supply. Exit barriers keep firms from leaving an industry when there is too much capacity, and prolong periods of excess capacity. In oil tanker shipping, for example, the exit barriers are very high because of the specialization of assets. This has translated into short peaks and long troughs of prices. Thus industry structure shapes the supply/demand balance and the duration of imbalances.
The consequences of an imbalance between supply and demand for industry profitability also differs widely depending on industry structure. In some industries, a small amount of excess capacity triggers price wars and low profitability. These are industries where there are structural pressures for intense rivalry or powerful buyers. In other industries, periods of excess capacity have relatively little impact on profitability because of favorable structure. In oil tools, ball valves, and many other oil field equipment products, for example, there has been intense price cutting during the recent sharp downturn. In drill bits, however, there has been relatively little discounting. Hughes Tool, Smith International, and Baker International are good competitors (see Chapter 6) operating in a favorable industry structure. Industry structure also determines the profitability of excess demand. In a boom, for example, favorable structure allows firms to reap extraordinary profits, while a poor structure restricts the ability to capitalize on it. The presence of powerful suppliers or the presence of substitutes, for example, can mean that the fruits of a boom pass to others. Thus industry structure is fundamental to both the speed of adjustment of supply to demand and the relationship between capacity utilization and profitability.
Generic Competitive Strategies
The second central question in competitive strategy is a firm's relative position within its industry. Positioning determines whether a firm's profitability is above or below the industry average. A firm that can position itself well may earn high rates of return even though industry structure is unfavorable and the average profitability of the industry is therefore modest.
The fundamental basis of above-average performance in the long run is sustainable competitive advantage. Though a firm can have a myriad of strengths and weaknesses vis-a-vis its competitors, there are two basic types of competitive advantage a firm can possess: low cost or differentiation. The significance of any strength or weakness a firm possesses is ultimately a function of its impact on relative cost or differentiation. Cost advantage and differentiation in turn stem from industry structure. They result from a firm's ability to cope with the five forces better than its rivals.
The two basic types of competitive advantage combined with the scope of activities for which a firm seeks to achieve them lead to three generic strategies for achieving above-average performance in an industry: cost leadership, differentiation, and focus. The focus strategy has two variants, cost focus and differentiation focus.
Each of the generic strategies involves a fundamentally different route to competitive advantage, combining a choice about the type of competitive advantage sought with the scope of the strategic target in which competitive advantage is to be achieved. The cost leadership and differentiation strategies seek competitive advantage in a broad range of industry segments, while focus strategies aim at cost advantage (cost focus) or differentiation (differentiation focus) in a narrow segment. The specific actions required to implement each generic strategy vary widely from industry to industry, as do the feasible generic strategies in a particular industry. While selecting and implementing a generic strategy is far from simple, however, they are the logical routes to competitive advantage that must be probed in any industry.
The notion underlying the concept of generic strategies is that competitive advantage is at the heart of any strategy, and achieving competitive advantage requires a firm to make a choice -- if a firm is to attain a competitive advantage, it must make a choice about the type of competitive advantage it seeks to attain and the scope within which it will attain it. Being "all things to all people" is a recipe for strategic mediocrity and below-average performance, because it often means that a firm has no competitive advantage at all.
Cost leadership is perhaps the clearest of the three generic strategies. In it, a firm sets out to become the low-cost producer in its industry. The firm has a broad scope and serves many industry segments, and may even operate in related industries -- the firm's breadth is often important to its cost advantage. The sources of cost advantage are varied and depend on the structure of the industry. They may include the pursuit of economies of scale, proprietary technology, preferential access to raw materials, and other factors I will describe in detail in Chapter 3. In TV sets, for example, cost leadership requires efficient size picture tube facilities, a low-cost design, automated assembly, and global scale over which to amortize R&D. In security guard services, cost advantage requires extremely low overhead, a plentiful source of low-cost labor, and efficient training procedures because of high turnover. Low-cost producer status involves more than just going down the learning curve. A low-cost producer must find and exploit all sources of cost advantage. Low-cost producers typically sell a standard, or no-frills, product and place considerable emphasis on reaping scale or absolute cost advantages from all sources.
If a firm can achieve and sustain overall cost leadership, then it will be an above-average performer in its industry provided it can command prices at or near the industry average. At equivalent or lower prices than its rivals, a cost leader's low-cost position translates into higher returns. A cost leader, however, cannot ignore the bases of differentiation. If its product is not perceived as comparable or acceptable by buyers, a cost leader will be forced to discount prices well below competitors' to gain sales. This may nullify the benefits of its favorable cost position. Texas Instruments (in watches) and Northwest Airlines (in air transportation) are two low-cost firms that fell into this trap. Texas Instruments could not overcome its disadvantage in differentiation and exited the watch industry. Northwest Airlines recognized its problem in time, and has instituted efforts to improve marketing, passenger service, and service to travel agents to make its product more comparable to those of its competitors.
A cost leader must achieve parity or proximity in the bases of differentiation relative to its competitors to be an above-average performer, even though it relies on cost leadership for its competitive advantage. Parity in the bases of differentiation allows a cost leader to translate its cost advantage directly into higher profits than competitors'. Proximity in differentiation means that the price discount necessary to achieve an acceptable market share does not offset a cost leader's cost advantage and hence the cost leader earns above-average returns.
The strategic logic of cost leadership usually requires that a firm be the cost leader, not one of several firms vying for this position. Many firms have made serious strategic errors by failing to recognize this. When there is more than one phpiring cost leader, rivalry among them is usually fierce because every point of market share is viewed as crucial. Unless one firm can gain a cost lead and "persuade" others to abandon their strategies, the consequences for profitability (and long-run industry structure) can be disastrous, as has been the case in a number of petrochemical industries. Thus cost leadership is a strategy particularly dependent on preemption, unless major technological change allows a firm to radically change its cost position.
The second generic strategy is differentiation. In a differentiation strategy, a firm seeks to be unique in its industry along some dimensions that are widely valued by buyers. It selects one or more attributes that many buyers in an industry perceive as important, and uniquely positions itself to meet those needs. It is rewarded for its uniqueness with a premium price.
The means for differentiation are peculiar to each industry. Differentiation can be based on the product itself, the delivery system by which it is sold, the marketing approach, and a broad range of other factors. In construction equipment, for example, Caterpillar Tractor's differentiation is based on product durability, service, spare parts availability, and an excellent dealer network. In cosmetics, differentiation tends to be based more on product image and the positioning of counters in the stores. I will describe how a firm can create sustainable differentiation in Chapter 4.
A firm that can achieve and sustain differentiation will be an above-average performer in its industry if its price premium exceeds the extra costs incurred in being unique. A differentiator, therefore, must always seek ways of differentiating that lead to a price premium greater than the cost of differentiating. A differentiator cannot ignore its cost position, because its premium prices will be nullified by a markedly inferior cost position. A differentiator thus aims at cost parity or proximity relative to its competitors, by reducing cost in all areas that do not affect differentiation.
The logic of the differentiation strategy requires that a firm choose attributes in which to differentiate itself that are different from its rivals'. A firm must truly be unique at something or be perceived as unique if it is to expect a premium price. In contrast to cost leadership, however, there can be more than one successful differentiation strategy in an industry if there are a number of attributes that are widely valued by buyers.
The third generic strategy is focus, This strategy is quite different from the others because it rests on the choice of a narrow competitive scope within an industry. The focuser selects a segment of group of segments in the industry and tailors its strategy to serving them to the exclusion of others. By optimizing its strategy for the target segments, the focuser seeks to achieve a competitive advantage in its target segments even though it does not possess a competitive advantage overall.
The focus strategy has two variants. In cost focus a firm seeks a cost advantage in its target segment, while in differentiation focus a firm seeks differentiation in its target segment. Both variants of the focus strategy rest on differences between a focuser's target segments and other segments in the industry. The target segments must either have buyers with unusual needs or else the production and delivery system that best serves the target segment must differ from that of other industry segments. Cost focus exploits differences in cost behavior in some segments, while differentiation focus exploits the special needs of buyers in certain segments. Such differences imply that the segments ate poorly served by broadly-targeted competitors who serve them at the same time as they serve others. The focuser can thus achieve competitive advantage by dedicating itself to the segments exclusively. Breadth of target is clearly a matter of degree, but the essence of focus is the exploitation of a narrow target's differences from the balance of the industry. Narrow focus in and of itself is not sufficient for above-average performance.
A good example of a focuser who has exploited differences in the production process that best serves different segments is Hammermill Paper. Hammermill has increasingly been moving toward relatively low-volume, high-quality specialty papers, where the larger paper companies with higher volume machines face a stiff cost penalty for short production runs. Hammermill's equipment is more suited to shorter runs with frequent setups.
A focuser takes advantage of suboptimization in either direction by broadly-targeted competitors, Competitors may be underperforming in meeting the needs of a particular segment, which opens the possibility for differentiation focus. Broadly-targeted competitors may also be overperforming in meeting the needs of a segment, which means that they are bearing higher than necessary cost in serving it. An opportunity for cost focus may be present in just meeting the needs of such a segment and no more.
If a focuser's target segment is not different from other segments, then the focus strategy will not succeed. In soft drinks, for example, Royal Crown has focused on cola drinks, while Coca-Cola and Pepsi have broad product lines with many flavored drinks. Royal Crown's segment, however, can be well served by Coke and Pepsi at the same time they are serving other segments. Hence Coke and Pepsi enjoy competitive advantages over Royal Crown in the cola segment due to the economies of having a broader line.
If a firm can achieve sustainable cost leadership (cost focus) of differentiation (differentiation focus) in its segment and the segment is structurally attractive, then the focuser will be ah above-average performer in its industry. Segment structural attractiveness is a necessary condition because some segments in ah industry ate much less profitable than others, There is of ten room for several sustainable focus strategies in ah industry, provided that focusers choose different target segments. Most industries have a variety of segments, and each one that involves a different buyer need or a different optimal production of delivery system is a candidate fora focus strategy. How to define segments and choose a sustainable focus strategy is described in detail in Chapter 7.
Copyright © 1985 by Michael E. Porter
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