What you will learn from reading Understanding Michael Porter
– The forces that impact a industries profitability.
– What real strategy is and how to apply it to improve your business.
– What disruptive innovation really is and how to identify it.
Understanding Michael Porter Book Summary
Understanding Michael Porter Book Summary distils Michael Porters’ main ideas and explains them in easy to understand terminology. In this summary, Magretta explains the relationship between porters 5 forces and profitability, the way to avoid competition and value chains create competitive advantage.
Screw Competition, The Aim – Not to compete:
“Competition to be the best will results in mediocre performance. Competition to be the best ultimately leads to destructive, zero sum competition.”
Think about it, there is simply no such things as ‘the best’ as there is difference in needs and wants.
Intense rivalries mean companies compete away the value they create. Therefore, you should compete to be unique. Strategic competition means choosing a path different from that of others.
Price competition most damaging caused by undifferentiated products. Once something becomes a commodity power shifts to customer.
Commoditisation combined with the internet has increased the power of buyers as they can shop around for the best price.
Prime Example: Airplane flights have been commoditised so the customer has been framed to shop for lowest price. This has led to success of price comparison sites to facilitate this new reality.
The Right Mind-set for Competition:
Be the Best
Be Number 1
Earn Higher Returns
Focus on market share
Focus on Profits
Serve ‘best’ customer with ‘best’ product
Meet diverse needs of target customers
Compete by imitation
Compete by innovation
(A race no one can win)
(Multiple winners, many events)
Industry Structure – The hidden profitability litmus test:
The structure of any industry is heavily influenced by some underlying economics.
Companies performance has two sources: Industry structure and relative position.
Industry structure is an exponentially more powerful and objective tool for understanding the dynamics of competition.
Industry structure determines profitability much more than growth (industry) tech etc..
Slow growth of industry = increase battle for market share. And market share isn’t a predictor of profitability.
There are limited number of structural forces at work in every industry they systematically impact profitability in a predictable direction.
Industrial structure takes a long time to change and remains fairly stable.
Vital questions to ask about Industry Structure:
- Why is current industry profitability? What is it? What’s popping up?
- What’s changing? How’s profitability likely to be affected?
- What limiting factors might be overcome to capture more of the value you create?
Porters 5 Forces and Profitability:
The five forces framework explains the industry’s average prices and costs, and therefore the average industry profitability you are trying to beat.
First, let’s get back to basics:
Profit = Price – Cost
Therefore all business profitability comes from price and cost variables.
Porters 5 forces all effect economics of a business as they effect price and cost differently.
Threat of entry increases – Prices decrease, costs increase
Supplier power – Costs increase
Buyer power – Prices decrease
Substitutes – Prices decrease, Costs increase
Rivalry – Prices decrease, Costs increase
The internet for example has made it easier for customers in an industry to shop around for the best price. The industry profitability should drop as in this instance the internet has meant the power fo buyers has increased in setting prices.
When assessing buyer power the channels through which products are delivered can be as important as the end users.
Buyers most likely to exercise their negotiating leverage if they are price sensitive.
Price sensitivity tends to increase if what they are buying is:
-Expensive relative to other costs or income
-Inconsequential to their own performance
Powerful suppliers will charge higher prices or insists on more favourable terms, lowering industry profitability.
-Powerful when industries need them more than they need industry
-Industries with high fixed costs are especially vulnerable to larger buyers
-Can credibly threaten to vertically integrate into producing industry’s product itself
Products or services that meet the same basic need as the industry’s in a different way, caps industry profitability.
Barriers to New entrants:
- Economies of scale
- Switching costs (can be cognitive i.e. learning new technology)
- Network effects
- Capital investments
- Access to distribution channels and proprietary tech
- Policies and regulations
How to think about industry structure strategically:
Can you position a company where the industry forces are weakest?
If you identify these leverage points in an industry, there is a lot to gain. Remember – Industry structure is dynamic not static. When you do Industry analysis, you are taking a snapshot of the industry at this point in time, but you are also assessing trends in the five forces.
Therefore new technologies and processes can help identify opportunities in industries.
A good strategy will result in a Profit and Loss sheet better than the industry average. This is because if you have real competitive advantage it means you operate at a lower cost, command a premium price or both.
ROIC (return on invested capital) is best measure for competitive success.
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 multi-dimensional nature of competition: creating value for customers, dealing with rivals and using resources productively.
Market share says we just want to be big, we don’t care if we make money doing it. Remember Goodharts law – chasing a specific measure makes it cease to be a useful measure. Market share tends to be a vanity project and doesn’t necessarily translate into larger profits.
If you’re pursuing a different positioning, then different metrics will be relevant.
What Real Differentiation is:
For Porter differentiation is where you are able charge a higher relative price.
Relative price: Sustainable premium price = unique + valuable to customer
Relative cost: More efficient ways to create, produce, deliver, sell and support your product or service. Put Simply– More efficiently using capital.
Competitive advantage and value chains:
By thinking in terms of value chains, 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.
Perform SAME activities as rivals, execute better
Perform DIFFERENT activities from Rivals
Meet same needs at a lower cost
Meet different needs and or same needs at lower cost
Cost advantage but hard to sustain
Sustainably higher prices and/or lower costs
Be the BEST, compete on execution
Be UNIQUE, compete on strategy
Zero in on the price drivers in your business model.
Key Question – Could you create superior value by performing activities in a distinctive way or activities competitions don’t perform?
Finding cost drivers requires detective work. Focus on certain activity to differentiate. Can this competency or ability be applied elsewhere?
Creating and visualising you value chain helps you identify each activity as adding some increment of value to the finished product or service. It identifies a whole world of relationships previously invisible to you.
Going one step further you to identify bottlenecks and what is and what isn’t working. You can then create a tailored configuration of activities to deliver the unique outcome you want.
Remember –Sustainable competitive advantage comes from a different configuration of activities.
If you see a good idea or innovation think about if it can reinforce your value chain or can be tailored to your strategy. And if possible try to make choices that are incompatible with competitors value chains.
You can apply core design elements used elsewhere. For Example an eye surgery used ford assembly line design – standardisation of activities and specialisation of labour and equipment to create a high volume production line that doesn’t stop. In the eye surgery industry.
The Value Proposition:
Target a customer group overlooked or avoided by the industry.
Needs can be both over and under served.
There’s no such thing as best value proposition for an industry. There’s only best at meeting a particular need at a particular price.
Strategy and Trade-Offs:
Strategy explains how an organisation, faced with competition, will achieve superior performance.
Strategic competition means choosing a path different from that of others. By definition strategy is about something unique, making a set of choices that nobody else has made. Strategy should be economically grounded and fact based and it should aim to shift relative price or relative cost in a companies favour.
Competition is full of economic trade-offs, these lie at the very heart of strategy. Trade-offs are choices that make strategies sustainable because they are not easy to match or neutralise. Strategy choices aim to shift relative price or relative cost in a company favour.
Strategy is implicitly a bet that the chosen customers or need and the essential trade-offs for meeting at the right price will be enduring.
Strategies often emerge through a process of discovery that can trade years of trial and error.
Strategy is all about making priorities clearer. A clear direction allows managers to tune out the many distractions around them.
Remember — Clarity about what you won’t do, then, is the best way to succeed and what you choose to do.
When you try to offer something for everyone, you tend to the relax the trade-offs that underpin your competitive advantage.
Rule of Thumb for identifying good strategy — There should always be a concise and memorable way to explain your strategy.
Finding Strategic Fit:
Good strategies depend on the connection many things, on making interdependent choices.
Each choice should enhance value of others.
Suboptimal choices in one area can optimise the whole.
You can create a value chain which generates customer enthusiasm to reduce spending on marketing.
3 types of fit:
- Consistency – so each activity is aligned
- Complement – where activities reinforce
- Substitution – choice substitutes need for something
Fit means that the whole matters more than any individual part.
Questions to identify strategic fit in your company:
What activities are generic and which are tailored?
Generic activities are activities that can’t be meaningfully tailored to a companies position (outsource?)
By throwing multiple obstacles in the path of would-be imitators, fit lowers the odds that a strategy can be copied.
5 signs of a good strategy:
- UVP (Unique value proposition)
- Tailored value chain
- Trade-offs different from rival
- Fit in value chain
- Continuity over time
Continuity and Flexibility:
Continuity reinforces a companies identity, it builds a companies brand, its reputation and customer relationships.
Continuity helps supplies, channels and other outside parties to contribute.
Continuity fosters improvements in individual activities and fit; it allows an organisation to build unique capabilities and skills tailored its strategy.
Flexibility causes an organisation that doesn’t stand for anything, a company needs direction.
When strategy needs to change:
- Customer needs change making a companies core value proposition obsolete.
- Innovation of all sorts can serve to invalidate the essential trade-offs on which strategy relies.
- A technological or managerial breakthrough can completely trump a companies existing value proposition.
Analysts lend people towards market favourites, shareholders place pressure to imitate winner (acquisitions).
The pressure to grow is among the greatest threats to strategy. Growth chasing tends to undermine competitive advantage.
How Business models differ from Strategy:
A business model highlights the relationship between your revenues and your costs. Strategy goes a step further. It looks at relative prices and relative costs and their sustainability.
So, the business model is best used as the most basic step in thinking about the viability of the company.
True Definition of Disruption:
“A disruptive technology is one that invalidates a value chain configuration and product configurations in a way that allows one company to leap above another.”
Disruptive technology is compelling as a metaphor, but managers need to be rigorous about what’s creating the disruption. How does it impact the value chain? Relative price? Relative cost?
So, basically a disruptive technology is one that invalidates important competitive advantages.
Questions to ask:
To what extent does it invalidate important traditional advantages?
To what extent can incumbents embrace the technology without major negative consequences for their business?