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-Minimum of 250 words to receive a score greater than 50% Article notes should be formatted for professional presentation Use headings, bold face type (where appropriate), bullets, and descriptions Competitive Advantage The Value Chain and Your P&L Applying Michael Porter’s Value Chain Framework to Your Business E x c e r p t e d f r o m Understanding Michael Porter: The Essential Guide to Competition and Strategy B y Joan Magretta Buy the book: Amazon Barnes & Noble HBR.org Harvard Business Review Press Boston, Massachusetts ISBN-13: 978-1-4221-8894-1 8890BC For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. http://hbr.org/product/understanding-michael-porter-the-essential-guide-t/an/13023-HBK-ENG?referral=00281&cm_mmc=npv-_-Chapters-_-2010-_-ProdReferrals http://hbr.org/product/understanding-michael-porter-the-essential-guide-t/an/13023-HBK-ENG?referral=00281&cm_mmc=npv-_-Chapters-_-2010-_-ProdReferrals http://www.amazon.com/gp/product/1422160599/ref=as_li_qf_sp_asin_tl?ie=UTF8&tag=harvabusin-20&linkCode=as2&camp=1789&creative=9325&creativeASIN=1422160599 http://www.barnesandnoble.com/w/understanding-michael-porter-joan-magretta/1102460887 http://hbr.org/product/understanding-michael-porter-the-essential-guide-t/an/13023-HBK-ENG?referral=00281&cm_mmc=npv-_-Chapters-_-2010-_-ProdReferrals Copyright 201 Harvard Business School Publishing Corporation2 All rights reserved Printed in the United States of America This chapter was originally published as chapter 3 of Understanding Michael Porter: The Essential Guide to Competition and Strategy, copyright 2012 Joan Magretta. 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CHAPTER 3 Competitive: Advantage The Value Chain and Your P&L NO TERM IS MORE closely associated with Porterthan competitive advantage. You hear it in compa- nies all the time, but rarely as Porter intended. Used loosely, as it most often is, it has come to mean little more than anything an orga- nization thinks it is good at. Implicitly, it is the weapon managers count on to prevail against their rivals. This misses the mark in important ways. 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. If strategy is to have any real meaning at all, Porter argues, it must link directly to your company’s financial performance. Anything short of that is just talk. For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. 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. In the last chapter, we saw how the five forces shape the industry’s average P&L. Industry structure, then, determines the performance any company can expect just by being an “average” player in its indus- try. Competitive advantage is about superior performance. In this chapter we’ll trace the roots of competitive advantage to the value chain, another key Porter framework. Economic Fundamentals Competitive advantage is a relative concept. It’s about superior per- formance. What exactly does that mean? The pharmaceutical com- pany Pharmacia & Upjohn had a seemingly impressive average return on invested capital of 19.6 percent between 1985 and 2002. During the same period, the steel manufacturer Nucor earned around 18 percent. Are these comparable returns? Should you conclude that Pharmacia & Upjohn had the superior strategy? Not at all. Relative to the steel industry, where the average return was only 6 percent, Nucor was a stellar performer. In contrast, Phar- macia & Upjohn lagged its industry, in which the superior performers earned more than 30 percent. (For an explanation of why Porter uses return on capital, see the box “Right and Wrong Measures of Com- petitive Success.”) In gauging competitive advantage, then, returns must be mea- sured relative to other companies within the same industry, rivals UNDERSTANDING MICHAEL PORTER2 For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. who face a similar competitive environment or a similar configura- tion of the five forces. Performance is meaningfully measured only on a business-by-business basis because this is where competitive forces operate and competitive advantage is won or lost. Just to keep our terminology straight, for Porter strategy always means “competi- tive strategy” within a business. The business unit, and not the com- pany overall, is the core level of strategy. Corporate strategy refers to the business logic of a multiple-business company. The distinction matters. Porter’s research shows that overall corporate return in a diversified corporation is best understood as the sum of the returns of each of its businesses. While the corporate parent can contribute to performance (or, as has been known to happen, detract from it), the dominant influences on profitability are industry specific. F I G U R E 3 - 1 The right analytics: Why are some companies more profitable than others? A company’s performance has two sources: INDUSTRY STRUCTURE RELATIVE POSITION Porter’s framework Five forces Value chain The analysis focuses on Drivers of industry profitability Differences in activities The analysis explains Industry average price and cost Relative price and cost If a company has a COMPETITIVE ADVANTAGE, it can sustain higher relative prices and/or lower relative costs than its rivals in an industry. 3 Competitive Advantage For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. Right and Wrong Measures of Competitive Success What is the right goal for strategy? How should you measure com- petitive 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. As any manager knows, goals—and how performance is mea- sured against them—have a huge impact on how people in organi- zations behave. Goals affect the choices managers make. Although managerial psychology has never been the central focus of Porter’s work, this insight about behavior informs his thinking. Start out with the wrong goal—or with goals defined in a misleading way— and you will likely end up in the wrong place. Performance, Porter argues, must be defined in terms that reflect the economic purpose every organization shares: to produce goods or services whose value exceeds the sum of the costs of all the inputs. 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 gener- ates versus all the funds invested in it, operating expenses and cap- ital. Long-term ROIC tells you how well a company is using its resources.* It is also, Porter points out, the only measure that * Note that the time horizon for evaluating ROIC will vary depending on the invest- ment cycle that characterizes the industry. In the aluminum industry, for example, where it can take eight years to bring a new smelter on-line, the appropriate time horizon is probably a decade. In contrast, three to five years is more appropriate for many service businesses. In a business with little capital, other measures of effec- tive resource use may be required. For example, a consulting firm might measure returns per partner. UNDERSTANDING MICHAEL PORTER4 For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. matches the multidimensional nature of competition: creating value for customers, dealing with rivals, and using resources pro- ductively. 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 sus- tainable way. The logic is clear and compelling. Yet when companies choose their goals—or when they accept the goals financial markets impose on them—this basic logic is often nowhere to be seen. When Porter questions why so few companies are able to maintain successful strategies, he often points to flawed goals as the culprit: • Return on sales (ROS) is used widely, although it ignores the capital invested in the business and therefore is a poor measure of how well resources have been used. • Growth is another widely embraced goal, along with its sister goal, market share. Like ROS, these fail to account for the capi- tal required to compete in the industry. Too often companies pur- sue unprofitable growth that never leads to superior return on capital. As Porter notes wryly when he talks to managers, most companies could instantly achieve rapid growth simply by cut- ting their prices in half. • Shareholder value, measured by stock price, has proven to be a spectacularly unreliable goal, yet it remains a powerful driver of executive behavior. Stock price, Porter warns, is a meaningful measure of economic value only over the long run. (For more on this, see Porter’s comments in the interview at the end of this book.) As Southwest Airline’s former CEO Herb Kelleher observes, flawed goals such as these lead to bad decisions. “‘Market share Competitive Advantage 5 For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. 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. Conversely, if a company is less profitable than its rivals, by definition it has lower relative prices or higher relative costs, or both. This basic economic relationship between relative price and relative cost is the starting point for understanding how companies create competitive advantage. has nothing to do with profitability,’ he says. ‘Market share says we just want to be big; we don’t care if we make money doing it. That’s what misled much of the airline industry for fifteen years, after deregulation. In order to get an additional 5 percent of the market, some companies increased their costs by 25 percent. That’s really incongruous if profitability is your purpose.’” Porter’s solution to this problem requires some courage: the only way to know if you are achieving the ultimate goal of creating eco- nomic value is to be brutally honest about the true profits you’ve earned and all the capital you’ve committed to the business. Strat- egy, 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. The same logic applies to nonprofits. Even though they operate in a world without market prices, and therefore without literal prof- its, the measure of performance should be the same: Does this organization use resources effectively? Measuring performance in the social sector is an equally tall order, one that is not undertaken as often or as rigorously as it should be. UNDERSTANDING MICHAEL PORTER6 For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. From here Porter takes us through a thought process that’s a lot like peeling an onion. First, disaggregate the overall profitability num- ber into its two components, price and cost. This is done because the underlying causal factors, the drivers of price and cost, are so differ- ent, and the implications for action are different as well. Relative Price A company can sustain a premium price only if it offers something that is both unique and valuable to its customers. Apple’s hot, must-have gadgets have commanded premium prices. Ditto for the high-speed Madrid-to-Barcelona train and the trucks Paccar creates for owner- operators. 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. For many years, U.S. automakers could sell basic passenger cars only by offering substantial rebates or other financial incentives rela- tive to companies such as Honda and Toyota. In 2010, a wave of new products from Ford was beginning to end that long-standing relative price disadvantage. The new Ford Fusion was a top pick of auto critics at Motor Trend and Consumer Reports, winning praise for qual- ity and reliability. Car buyers seemed to agree. Of the record $1.7 bil- lion Ford earned in the third quarter of 2010, Ford attributed $400 million to higher prices. In industrial markets, value to the customer (which Porter calls buyer value) can usually be quantified and described in economic terms. A manufacturer might pay more for a piece of machinery because, compared with lower-priced alternatives, it will produce off- setting labor costs that exceed the higher price. With consumers, buyer value may also have an “economic” compo- nent. For example, a consumer will pay more for prewashed salad in order to save time. But rarely do consumers actually figure out what Competitive Advantage 7 For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. they are paying for convenience, in the way a business customer would. (I once calculated, for example, that consumers were effec- tively paying well over $100 an hour for the unskilled labor involved in grating cheese.) A consumer’s WTP is more likely to have an emotional or intangi- ble dimension, whether it is the trust engendered by an established brand or the status associated with owning the latest electronic gadget. Automakers are betting that consumers will pay a price pre- mium for hybrid cars that well exceeds their potential savings from lower fuel costs. Clearly, noneconomic factors are at work in this calculation. The same is true in a small but growing corner of the food business. Why are consumers increasingly willing to pay price premiums of three or four hundred percent for what has long been a basic com- modity, a carton of eggs? There are a variety of explanations, all of them related to a growing awareness of how eggs are produced on fac- tory farms. For the health-conscious customer, the added value is food safety. For the farm-to-table enthusiast, it’s better taste. For the animal ethicist, it’s the humane treatment of the hens that lay the eggs. The ability to command a higher price is the essence of differentiation, a term Porter uses in this somewhat idiosyncratic way. Most people hear the word and immediately think “different,” but they might apply that difference to cost as well as to price. For exam- ple, “Ryanair’s low costs differentiate it from other airlines.” Mar- keters have their own definition of differentiation: it’s the process of establishing in customers’ minds how one product differs from oth- ers. Two brands of yogurt may sell for the same price, but you’re told that Brand A has “50 percent fewer calories.” Porter is after something different. He is focused on tracking down the root causes of superior profitability. He is also trying to encourage more precise and rigorous thinking by underscoring the distinction UNDERSTANDING MICHAEL PORTER8 For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. between price effects and cost effects. 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 rela- tive 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 effi- ciently (including working capital), or both. Dell Inc.’s low relative costs up through the early 2000s came from both sources. Vertically integrated rivals, such as Hewlett-Packard, designed and manufactured their own components, built computers to inventory, and then sold them through resellers. Dell sold direct, building computers to customer orders using outsourced components and a tightly managed supply chain. These competing approaches had very different cost and investment profiles. Dell’s model required little capital since the company did not design or make components, nor did it carry much inventory. In the late 1990s, Dell had a substantial advantage in days of inventory carried. Because component costs were then dropping so fast, buying components weeks later, as Dell effec- tively did, translated into lower relative costs per PC. And Dell’s cus- tomers actually paid for their PCs before Dell had to pay its suppliers. Most companies have to finance the working capital they need to run their business. Dell’s strategy resulted in negative working capital, which further enhanced Dell’s cost advantage. Competitive Advantage 9 For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. Sustainable cost advantages normally involve many parts of the com- pany, not just one function or technology. Successful cost leaders multi- ply 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, as it does with companies as diverse as Vanguard (financial services), IKEA (home furnishings), Teva (generic drugs), Walmart (discount retailing), and Nucor (steel manufacture). Not only has Nucor historically achieved cost advantages in production, for example, but for years it ran a multibillion-dollar company out of a corporate headquarters about the size of a dentist’s office. The “exec- utive dining room” was the deli across the street. The big idea here is this: strategy choices aim to shift relative price or relative cost in a company’s favor. Ultimately, of course, it’s the spread between the two that matters: any strategy must result in a favorable relationship between relative price and relative cost. A dis- tinct strategy will produce its own unique structure. One strategy might, for example, result in 20 percent higher costs but 35 percent higher price. Companies such as Apple or BMW lean in that direction. Another strategy might lead to 10 percent lower costs and 5 percent lower price. Companies such as IKEA and Southwest have chosen this kind of structure. Where the net result of the configuration is positive, the strategy has, by definition, created competitive advantage. For Porter, thinking in such precise, quantifiable terms is essential because it ensures that strategy is economically grounded and fact based. Strategy choices aim to shift relative price or relative cost in a company’s favor. The same big idea applies to nonprofits as well. Remember, com- petitive advantage is fundamentally about superior value creation, UNDERSTANDING MICHAEL PORTER10 For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. about using resources effectively. Strategy choices for nonprofits aim to shift relative value or relative cost in society’s favor. In other words, a good strategy would enable a nonprofit to produce more value for society (the analogue of higher price) for every dollar spent, or to pro- duce as much value using fewer resources (the equivalent of lower cost). To apply Porter’s ideas in a nonprofit setting, keep in mind that the nonprofit’s goal is to meet a specific social objective with the greatest efficiency. On this score, for-profit managers have it easier. Market prices give them a clear yardstick against which to measure the value they create. Nonprofit managers face the same task, creat- ing value, but without the clarity of that yardstick. The Value Chain We now have a concise, concrete definition of competitive advantage: superior performance resulting from sustainably higher prices, lower costs, or both. But we have to peel one final layer of the onion to arrive at what I’ll call the managerially relevant sources of competitive advantage—the things that managers can control. Ultimately, all cost or price differences between rivals arise from the hundreds of activities that companies perform as they compete. We need to slow down here for a minute because this is really important and because this language is not intuitive for most man- agers. Since I’m going to be referring to activities and activity systems a lot, let’s be clear about the definition. 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, some- times working capital, and various types of information. Managers tend to think in terms of functional areas such as mar- keting or logistics because that is how their own expertise or organiza- Competitive Advantage 11 For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. tional affiliation is defined. That’s too broad for strategy. To under- stand competitive advantage, it is critical to zoom in on activities, which are narrower than traditional functions. Alternatively, man- agers 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 activ- ities 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. The sequence of activities your company performs to design, pro- duce, sell, deliver, and support its products is called the value chain. In turn, your value chain is part of a larger value system: the larger set of activities involved in creating value for the end user, regardless of who performs those activities. An automaker, for example, has to equip a car with tires. This involves a number of upstream choices: Do you make the tires yourself or buy them from a supplier? If you make them yourself, do you buy raw materials from a supplier or do you produce them yourself? Henry Ford famously chose to operate his own rubber plantation in Brazil in the late 1920s, a decision that did not turn out too well. Ultimately, choices like this, about how ver- tically integrated you want to be, are choices every company makes about “where to sit” in the value system. UNDERSTANDING MICHAEL PORTER12 For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. There are also activity choices to be made looking downstream in the 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 activ- ities affects your cost or your price, and vice versa. The value chain is another Porter framework that managers refer to all the time. Most, I believe, know what a value chain is—the metaphor of a series of linked activities is intuitive. But many miss the “so what.” Why does it matter? The answer: The value chain is a powerful tool for disaggregating a company into its strategically rele- vant activities in order to focus on the sources of competitive advan- tage, that is, the specific activities that result in higher prices or lower costs (or, if your organization is a nonprofit, the activities that result in higher value for those you serve or lower costs in serving them). Key Steps in Value Chain Analysis The best way to appreciate this tool is actually to use it. Here’s how. 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 busi- ness. The industry’s value chain is effectively its prevailing business model, the way it creates value (see figure 3-2). It is where most Competitive Advantage 13 For the exclusive use of x. nie, 2021. This document is authorized for use only by xiaoqing nie in Fall 2021 Strategic Management-1 taught by Matthew Fisher, San Francisco State University from Aug 2021 to Feb 2022. companies in the industry have chosen “to sit” in relation to the larger value system. How far upstream do the industry’s activities extend? Does the industry do basic research? Does it design and develop its products? Does it manufacture? What key inputs does it rely on? Where do they come from? How does the typical player in the industry market, sell, distribute, deliver? Is financing or after-sales service a part of the value the industry creates for customers? Depending on the industry, some categories will be more or less important in competitive advantage. The key here is to lay out the major …