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

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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.

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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

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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

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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

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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

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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

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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

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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

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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

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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

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