What Is Strategy

Michael Porter - Tomorrowday II

September 26, 1996

As insightful as Sherry Turkle and Francis Fukuyama were, the star of Tomorrowday II, and the reason over 600 people sat for eight hours in orchestra Hall, was undoubtedly Michael Porter.

You might call Michael Porter the "Father of Competitive Strategy," because his name is inextricably linked with the art and science of shaping companies to capitalize on future change. He divided his talk Thursday into two parts:

• the first was a summary of the right and wrong ways to conduct strategy,
• and the second was a discussion of the geographic variation of success.

This Thing Called Strategy

 

Strategy, Michael Porter, isn't what most people think it is. It isn't crystal-balling, deal-making, or customer-pleasing. At times, it can be the exact opposite of those things. Getting a proper understanding of the nature of strategic thinking is perhaps the most important function an organization has; misunderstanding strategy is a shortcut to failure.

Porter starts with three premises. The first is that the central goal of any company must be superior long-term return on investment -- profit. The second its that the fundamental unit of strategic analysis is the industry, And the third is that company performance is affected by two dynamics that are distinct from one another, but each roughly as important as the other:

• the structure of the industry the company is in, and
• the company's position within that industry.

To be successful, a strategist must be a master of both dynamics, of the industry and of the individual company.

Porter explained the reason for this distinction. Some industries have inherently a higher profit range than others. Pharmaceutical companies have enjoyed an average annual profit of 24% over the years from 1982-1993; trucking companies' profits have averaged 10% over the same period. Clearly, all the company strategy in the world won't achieve much if you're stuck in a low-margin industry.

What makes a high-margin industry? Porter answered that question by turning it around: what keeps an industry from high margins are:

1. The availability of substitute products.
2. Suppliers and customers with a high degree of bargaining power.
3. Price competition between companies within the industry.
4. The ever-present threat of new entrants.

These conditions add up to a plain-vanilla industry in which differentiation is difficult. Trucking suffers from these strictures; theirs is a dog-eat-dog world of low-margin competition. By comparison, the pharmaceutical industry is a gold mine, and while it faces its share of challenges, it enjoys an obviously more favorable industry environment:

1. Over-the-counter medications put pressure on prescription drugs.
2. Suppliers are not in a strong position because the materials in drugs are largely commoditized. Large buyers, however, like hospitals and retailers like Wal-Mart, are in a stronger position to negotiate price because of their size.
3. The move to generic drugs is putting price pressure on the makers of ethical drugs.
4. For drug companies, competition may arise from biotechnology companies or through joint marketing arrangements.

What can drug companies do to address changes in their industry? Porter divides responses into those which react to change and those which are proactive in reshaping the industry.

Reactive companies try to put out fires, lobbing against unwanted changes, cutting costs, buying out competitors, and forming strategic alliances with horizontal biotech companies.

All well and good, but a proactive company shows more imagination. Instead of buying competitors, it buys distributors, allowing it to improve and economize that process. Instead of marketing to the same old markets, it opens up a new initiative, marketing directly to customers. Instead of fighting against generic competitors, it joins them, offering generic versions of its own products.

Thus we arrive at Porter's first law: while company-oriented companies strategize by seeking out the best deals to exploit existing opportunities, and by seeking to offer the best products, industry-oriented companies try to commandeer the evolution of the industry itself, to make it less like trucking and more like pharmaceuticals.

"A lot of companies ignore the industry part and focus on position, and that is a serious mistake," Porter said. "You can do more to boost profits by making industry better than making your products better." Good always comes from shaping your industry's structure, he said -- ideally in such a way that your company can win.

Beating the Next Guy

There is one school of thought which holds that you can't beat the other guy, day in and day out. Advantage cannot be sustained, by definition. Porter says this is absurd, because the evidence shows that lots of companies have managed to make more money than their competitors, decade after decade.

Two factors contribute to competitive advantage, in Porter's view: differentiation of products and services and what it costs a company to produce or deliver them. Companies that win in all weather surpass their competitors in either one or the other, or both.

Porter said that he isn't wild about the phrase "core competencies," meaning those skills an organization has that are unique to it. Feeling that phrase is too mushy, he prefers simply those "activities." A company is really nothing more than a collection of these discrete activities, in which competitive advantage resides.

He divides activities into primary activities:

• inbound logistics (e.g., material storage. data collection, customer access)
• operations (e.g., assembly, component fabrication, branch operations)
• outbound logistics (e.g., order processing, warehousing, report preparation
• marketing and sales (e.g., sales force, advertising, trade shows, proposal writing), and
• after-sales service (e.g., installation, customer support, repair)

And abutting these are the organization's support activities:

• firm infrastructure (e.g., financing, planning, investor relations)
• human resource management (e.g., recruiting, training, compensation)
• technology development (e.g., product design, testing, process design, material research, market research), and
• procurement (e.g., components, machinery, advertising, services).

Put 'em all together -- noting that they include areas well outside the definition of core competencies -- and they contribute to a company's profit margins, the return on investment that, after all, is the key to strategy.

Strategy and Operational Effectiveness

Too many organizations pin their strategic thrust on improving operational effectiveness, Porter said. Operational effectiveness means doing more or less same thing as your competitors, only better.

Companies around the world have thrown themselves at improving operational effectiveness, achieving best practice levels in quality, technology, the elimination of waste and continuous improvement. We are all trying desperately to function on the "productivity frontier," a zone Porter describes that exists where product and service differentiation and relative cost position are at their most optimal points.

In Porter's zone, Japanese companies were functioning along that coveted frontier for years, while American companies wee drawn in from it, at a position he described as "mediocre." So, obviously, American companies needed to improve operations so that they, too, existed out along that frontier.

But there's a catch: while it is absolutely imperative that companies match new world standards for productivity, quality, and efficiency, those things don't amount to strategic thinking. They are "necessary but not sufficient," the price of playing today's game. It is our fate that we can be doing our absolute best and still be mediocre, because mediocre is a lot better today than it used to be. Porter calls this clustering along the frontier competitive convergence.

Instead of improving operational effectiveness and calling that strategy, we need to create for our companies a unique and sustainable competitive position. And that's strategy.

The Joy of Tradeoffs

Strategy means choosing to perform activities differently than rivals. If they are all chocolate, you be vanilla. If they are vanilla, be something else. Porter said there only three approaches to this differentiation are based in:

• variety (providing varieties or features of your product/service no one else is providing;
• needs (meeting the needs of a customer group no one else is serving);
• access (reaching customers no one else is reaching).

As an example of variety-based positioning, Porter offered Neutrogena, makers of the medicinal soap. Instead of making a generic soap like a Palmolive or Ivory, Neutrogena focused on the unique activities that made its business different. Its soap was formulated to be pH-balanced, sold only in drugstores, and advertising in medical journals. By being in every way a different kind of product than competitors, Neutrogena has found a place for itself in the marketplace.

Other examples:

• Southwest Airlines, which has succeeded by targeting short-haul, point to point air service between medium-sized cities. Once that needs targeting was done, the famous Southwest no-frills formula (no seat assignments, meals, baggage checking or first class seating) fell into place.
• Vanguard Group, which doesn't try to buy the best-performing stocks, but focuses instead on lowest overall fee structure.

As an example of needs-based positioning, Porter offered IKEA, Swedish maker of low-priced, ready-to-assemble furniture. By identifying a customer base no one else seemed to want -- young families willing to do some of the work themselves -- IKEA has prospered.

And as an example of access-based positioning, Porter offered Carmike Cinemas, which chose to avoid larger markets for its low-budget theater complexes and to focus instead on small cities and towns with populations under 200,000.

The key to these distinguishing distinctions is that they all involve trade-offs. Having decided to appeal to a health-oriented part of the market, Neutrogena had to forego making and selling a mass-market soap like Dial. Having decided on low-price as a positioning feature, IKEA could not plausibly launch a high-end series of products as well. No strategic position can be sustained unless there are tradeoffs with other positions. Tradeoffs reflect incompatibilities between positions that force a company to choose A or B, but not both.

Companies that do try to be all things to all markets, to choose A and B, are guilty of straddling. Continental Airlines tried to copy Southwest with its own bargain brand, Continental Lite. It was a noble experiment, but it has failed because Continental did not overhaul its structure to accommodate the new service offering. Continental matched Southwest's prices but could not match its costs -- a formula for catastrophe. Ultimately, Continental's CEO was sacked for the new division's failure.

So the incomplete strategy sees itself as a race to an ideal position, while the complete strategy makes tough choices, trading off one good thing for something even better. Forget "core" competencies, "critical" resources, and "key" success factors, which Porter feels are neither core, nor critical, nor key. Focus instead on competencies, resources, and factors that fit with a company's strategic plan.

Fit to be Tried

The key to successful tradeoffs is to make the right ones. The essential activities of your organization must fit together. Strategic fit is the process of aligning organizational activities so that they reinforce one another, and so that the configuration of one activity rases the value of other activities. The fit at Southwest Airlines includes many activities that the casual observer might not consider critical -- no connections to other airlines, for instance. But that feature (or non-feature) is of a piece with the idea that has made Southwest so successful. It fits. The same can be said for product sampling of Neutrogena soaps at fine hotels, or the absence of 12b-1 fees at Vanguard's mutual funds.

In the end, Porter said, there is no greater failure in strategic thinking than the failure to choose -- to make the tradeoffs necessary to distinguish your firm from your competitors. Sometimes, as at Southwest, this means the customer is wrong. These tradeoffs can be scary, and make no mistake, you will be held accountable for your choices.

But without them, there is not only little of achieving the operational efficiencies which are indispensable in today's competitive environment, but even less hope of being a company people can understand at a glance, and do business with.