By: Michael E. Porter
28-MINUTE AUDIO / 3,500 WORDS (12 PAGES)
How do you out-perform competitors and acquire a better understanding of key profitability drivers in your industry?
This book, by the legendary Michael Porter, has redefined how Fortune 500 companies formulate strategy and has become essential reading in top MBA programs worldwide.
Read this summary to unlock the analytical tools that govern competition and profitability, predict competitor moves, and create game-changing strategy.
TOP 20 INSIGHTS
The competition in an industry and the ultimate profitability of a firm depend on five fundamental competitive forces: ease of entry, threat of substitution, bargaining power of buyers, bargaining power of suppliers, and rivalry among competitors. Competitive strategy aims to create a defensible position for the firm against the five competitive forces with offensive or defensive tactics.
The threat of new entrants in an industry can be analyzed with Entry Deterring Price. The Entry Deterring Price is the price at which the rewards of entry are equal to the expected costs of overcoming barriers. New firms will enter if the existing or projected future price is higher than the Entry Deterring Price. Incumbent firms can prevent entry by driving prices below the Entry Deterring Price.
Advantages like proprietary technology and favorable locations are hard to replicate for a new entrant regardless of size or economy of scale. In some industries, unit costs decline with experience as worker effectiveness improves, and better product designs are evolved. Therefore, newer firms will incur higher costs than established firms and must spend more to be competitive.
High exit barriers increase competition in an industry as companies that lose the competitive battle do not give up. High exit barriers can be due to assets that cannot be readily liquidated, labor agreements, or even management's emotional commitment to the industry.
Profitability is high when entry barriers are high, which make entry difficult and lower exit barriers to allow unsuccessful competitors make quick exits.
Products that perform the same function can become substitutes to an industry's products. This increases competition and threatens profitability. The risk is greater when substitutes offer a higher price-performance tradeoff.
The bargaining power of buyers can reduce profitability. Therefore, choice of target segment is a critical strategic decision. A company’s strategic position improves when you sell to buyers or segments who have the least bargaining power.
The role of government as a buyer, supplier, or determiner of policy can be significant in many industries. Structural Analysis considers its impact on competition by seeing how it influences competition through the five competitive forces.
Structural Analysis can be used to predict the future structure and profitability of industry-enabling firms to plan strategic maneuvers ahead of the curve. To do this, forecast the magnitude of each competitive force based on underlying causes and construct a composite picture.
The three major competitive strategies are: 1) establish cost leadership, 2) create product differentiation, and 3) focus on a specific market segment. When a firm falls in the middle and doesn’t have strong focus on any of these three directions, it suffers low profitability.
The competitor response profile enables firms to find the best strategic position in the market. This is based on an understanding of the competitors' goals and assumptions to make effective moves and avoid retaliation.
Firms have an understanding of themselves and their competitors that guide the way the firm responds to events. When these assumptions are examined, the firm can uncover blind spots to be strategically leveraged with little or no retaliation.
Market signals are competitor actions that reveal their motivation, strategic direction, or internal situations. These can be indicators of commitment to a course of action or bluffs to mislead other firms. When you ignore market signals, you also ignore competition.
A firm makes a cross-parry when it responds to a competitor's move in one area by countermoves in another area. If the moves are directed at core markets, it is a strong warning signal. A variant is the Fighting Brand, usually a clone of the competitor product, which is introduced as a threat or retaliation.
Brute force approaches to gain dominance are inadequate as they demand clear superiority, excessive resources, and a war of attrition. Skillful competitive moves structure the field in such a manner that it maximizes the firm's outcomes but also avoid a costly war of attrition.
When a firm consistently reacts with firmness to a competitor move, it sets the expectation that aggressive moves will be met with retaliation. This disciplining action is effective when it is specific and explicit.
Communications of commitment makes the firm’s intentions clear to its competitors and is a way to prevent aggressive moves. The credibility of a commitment depends on the resources to carry out the commitment effectively, a history of credible commitments, and ability to demonstrate compliance with the commitment through metrics.
A Strategic Group is a set of firms that follow similar strategies, have similar market shares, and respond similarly to strategic events. This is a level of analysis between the industry-wide view and individual competitor analysis. The five competitive forces will have unequal impacts on different strategic groups.
The timing of a firm's entry into a strategic group has an impact on its profitability. In some industries, it is difficult for late entrants into strategic groups to establish themselves. In others, technological leapfrogging may give latecomers extraordinary advantages.
A key element of competitive strategy is to choose the strategic group to compete in, strengthen the existing group, or create an entirely new strategic group.
The industry in which a firm operates determines the rules of the game and the strategic options available to it. The profitability and degree of competition in an industry depend on five fundamental competitive forces:
Threat of substitution
Bargaining power of buyers
Bargaining power of suppliers
Rivalry among competitors
Structural Analysis based on these five forces gives a clear understanding of strategic opportunities, threats, and the ultimate profit potential in an industry. This is necessary for formulating effective competitive strategy.
THE FIVE COMPETITIVE FORCES
1. Threat of Entry
New entrants can shake-up an industry, gain market share, and drive down profitability. The risk of entry depends on the barriers to entry and the reaction of existing firms. The significant barriers to entry are:
Economies of scale: High economies of scale make entry difficult. The newcomer has to enter at scale or suffer a price disadvantage.
Product differentiation: New entrants must spend heavily to overcome established brand loyalties. This is seen in industries like baby care products and investment banking.
Capital requirements: The need for large high-risk investments upfront can be a strong entry barrier.
Switching costs: Switching costs are one-time costs like training and buying new equipment that buyers face while switching to a new product. If there are high switching costs, buyers will not shift to a new supplier unless there is a significant improvement in cost or quality.
Access to distribution channels: New firms must persuade distribution channels to take up its product through measures like discounts and intense promotions. Limited channels and exclusive channel partnerships can further increase entry barriers, sometimes even force entrants to create new distribution channels.
Cost disadvantages independent of scale: Some advantages of incumbent firms like proprietary technology, favorable locations, and government subsidies cannot be replicated irrespective of size or economies of scale.
Government policy: Policies like licensing requirements, limited access to raw materials, and even pollution control requirements can increase the capital and technological sophistication required for entry.
Expected retaliation: The entry barrier increases if existing competitors have a history of forceful retaliation using substantial resources.
The entry deterring price: balances the rewards from the entry with expected costs of overcoming barriers. If the existing or projected future price is higher than the entry deterring price, the entry will occur. Incumbents can prevent entry by driving prices below the entry deterring price.
Intensity of Rivalry
Some forms of competitive rivalry, like competitive price cuts, can make the entire industry less profitable. Others like advertising for expanding demand can benefit all firms. Intense competition occurs due to structural factors. They include:
Many or equally balanced competitors: Large number of firms increases the possibility of a firm's erratic behavior triggering competitive warfare. In an industry dominated by a few firms, the leaders can impose discipline and create coordination.
Slow industry growth: Slow growth can set off intense competition for market share.
High fixed or storage costs: High fixed costs create intense competition.
Lack of differentiation: When the products are seen as undifferentiated commodities, it creates severe price and service competition. Product differentiation reduces competition as buyers have brand preferences.
Diversity of competitors: Diverse firms have different strategic goals and tactics, making it hard to arrive at standard "rules of the game" for the industry.
High strategic stakes: Some firms may consider achieving success in an industry to be strategically important, even at the cost of profitability. This can fuel intense competition.
High exit barriers: High exit barriers, including assets that can't be readily liquidated and management's emotional commitment to the industry, increases competition as companies that lose the competitive battle do not quit.
Companies can make strategic shifts to improve conditions. Examples include raising switching costs by providing custom products and creating product differentiation through branding or service.
Threat of Substitution
Substitutes to an industry's products can be identified by looking for other products that perform the same function, not necessarily from the same industry. The highest risk comes from substitute products that have higher price-performance tradeoff than the industry's products or those produced by highly profitable industries.
Bargaining Power of Buyers
Buyers can bargain for higher quality, more services, or play competitors against each other to reduce profitability. The power of buyers increases under the following conditions:
There are large volume purchases
Other products can easily substitute the product
Lower switching costs
Low-profit buyers tend to lower purchasing costs
Buyers threaten backward integration as a bargaining lever
The product does not affect the quality of the buyer's products
The buyer has complete information about demand, market prices, and supplier costs
Choosing whom to sell to is a strategic decision for a company. Selling to buyers or segments who have the least bargaining power improves a company's strategic position. For example, the replacement market has lesser power than the OEM market.
Bargaining Power of Suppliers
Suppliers can reduce profitability by threatening price rises or reducing the quality of goods. Supplier groups become powerful when:
A few players dominate
When they do not have to compete with substitutes
The industry is not an important customer group
The product is essential to the buyer's business
The products are differentiated, or switching costs are high
When suppliers pose a credible threat of forward integration
THREE EFFECTIVE COMPETITIVE STRATEGIES
An effective competitive strategy aims to create a defendable position against the five competitive forces through offensive or defensive tactics. This can be done by positioning the firm in a way that makes it defensible against the five forces and creating strategic moves that balance forces and anticipate shifts in forces. There are three broad strategic approaches to outperform competition: 1) overall cost leadership, 2) differentiation, and 3) focus.
1. Overall Cost Leadership
Having a lower cost than competitors gives higher than average returns, even when there are strong competitive forces. It defends against rivals, as the firm earns profits even after other opponents competitively lower prices. Buyers cannot drive down costs further. The flexibility to handle cost increases defends it against suppliers. The scale and cost advantages from cost leadership create high entry barriers. Low cost also gives advantages against substitutes.
Implementing this strategy may require high upfront capital investment in quality equipment, aggressive pricing and startup losses. This strategy generates surplus capital which can be reinvested to maintain cost leadership. Cost leadership can be used to disrupt industries where price competition is low, and leaders are unprepared for cost minimization.
However, cost leadership runs the following risks: a new technology that nullifies cost advantages, inability to see market shifts due to sole cost focus, and cost inflation that narrows cost leadership and makes differentiated competitors more attractive.
Product differentiation creates brand loyalty that protects against competitive rivalry and creates high entry barriers. It reduces the power of buyers and protects against substitutes, as there are no apparent alternatives. Finally, it gives high margins that help cope with the power of suppliers. Differentiation may require preserving a perception of exclusivity that may prevent gaining a high market share. Further creating differentiation may involve high costs like extensive research, product design, and high-quality materials.
This strategy involves risks such as:
The cost differential between the firm and low-cost competitors becomes too high, offsetting brand loyalty
Buyer demand for differentiation reduces
Imitation goods reduce perceived differentiation
This strategy is built around serving a particular buyer group, segment, or geography more effectively than generic competitors. This can help the firm achieve differentiation or cost leadership within its narrow market. However, this strategy can limit market share achievable.
The potential downfalls include:
The product difference between the target market and the overall market narrows
Competitors find submarkets within the target market to out-focus the firm
Each of these strategies requires sustained commitment, along with specific resources, organizational arrangements, and skills. A firm that falls in the middle without orienting in any of these three directions will suffer from low profitability. It loses high volume customers who demand low costs while losing out on top margin customers who require niche products or differentiation. The firm must clearly orient itself towards one of these approaches based on analysis of the industry and its own strengths.
A FRAMEWORK FOR COMPETITOR ANALYSIS
Understanding the strategic goals, moves, and potential responses of existing and potential competitors is essential to strategy formulation. There are four components to creating a competitor's response profile. Based on these four components, a competitor response profile can be created to detail possible offensive moves and defensive capability.
1. Understand Future Goals
This can help a firm predict the competitor's strategic moves and response to industry changes. This includes understanding financial goals and other qualitative factors like an aspiration for market leadership and technological position. When competitors goals are understood, it may be possible to create situations where everyone is reasonably satisfied. It also helps firms avoid strategic moves that create intense rivalry by upsetting the critical goals of competitors.
Firms have an understanding of themselves and their competitors to guide the way the firm responds to events. Examples include seeing itself as an industry leader, a socially conscious firm, and a low-cost producer. Examining these assumptions can help uncover blind spots which can be strategically leveraged with little or no retaliation. Studying the past record of the firm provides valuable insights on how it perceives itself, its goals, and how it responds to change.
3. Current Strategy
It's essential to develop a statement of each competitor's strategy in terms of key operating policies in each functional area and their interrelations.
The competitor's strengths and weaknesses concerning the five competitive forces will determine the competitor's ability to respond to strategic moves. It is crucial to understand core capabilities, ability to react rapidly to offensives, ability to adapt to change, and staying power along with understanding strengths in each business area.
The firm must select the best strategic position based on the vulnerabilities and weaknesses of the competitors. This involves taking advantage of the competitor's goals and assumptions to use one's advantages and avoid retaliation. Another approach could be to create conflict between the two goals of a competitor.
READING MARKET SIGNALS
Market signals are actions by competitors that indicate their intentions, motives, or internal situations. They can either be indicators of motives or bluffs designed to mislead other firms. These signals can be deciphered based on the competitor profile created through competitor analysis. Ignoring market signals equals to ignoring competition. Key types of market signals are:
1. Prior Announcement of Moves
A firm formally announces a course of action that it may or may not follow through with action. This can be used to preempt competitors from taking a course of action, threaten retaliation to a planned move and as a way to test reactions to planned steps.
2. After-the-fact Announcements
These announcements share data and updates about actions or sales figures. Such announcements can be signals to other firms.
3. Comments on Industry
Comments made by the firm about the state of the market and future growth can reveal their assumptions and expectations. There are also comments about a competitor's moves that could signal pleasure or displeasure.
4. Explanations of Moves
Firms publicly explain their moves to make the industry not see them as provocations or communicate commitment to a strategic direction.
5. Cross Parry
This happens when a competitor indirectly counters a firm's move with moves in another area. If it is directed at a peripheral market, it can be read as a minor warning, whereas if it is directed at the firm's core market, it must be construed as a more severe warning. Maintaining a small position in cross-markets is a useful way to send signals through cross-parrying.
6. The Fighting Brand
A fighting brand is usually a product clone that is introduced to threaten or punish a competitor. A classic example is when Coca-Cola introduced Mr.Pibb to counter Dr. Pepper in the 1970s.
The principal objective of a competitive move is to maximize outcomes while avoiding a costly war of attrition. A brute force approach is inadequate as it demands clear superiority, excessive resources, and a war of attrition.
Cooperative or Non-threatening Moves
Firms can improve position without threatening competitor goals. These could be:
Moves that will enhance positions of both the firm and its competitors even if they do not follow suit. These are rare.
Moves that improve the position of the firm and its competitors if a significant number follow suit. An example could be calling for a price adjustment.
Moves that improve position because competitors won't match them. This can be because the market or strategy is perceived as unimportant to their strategic goals. Swiss luxury watchmakers did not respond to Timex's entry into the low-price watch segment as they did not see it as competition.
All three categories can possibly be misinterpreted as aggression. Therefore, active market signaling through public announcements is required.
The key to managing threatening moves is to be able to anticipate and influence retaliation. Competitor analysis helps predict the likelihood, speed, and magnitude of the reaction. The firm will choose to make moves that give it maximum time before a competitor responds. Response lags can happen due to the following reasons:
A low-profile move can buy time before it is seen as a threat
Retaliation to certain kinds of moves may require time. An R&D breakthrough might take years for competitors to replicate
Retaliation may be delayed because responding might conflict with other goals of the competitor. When the Swiss Watch companies began to see Timex as a threat, they could not react as competing with a budget brand would undermine their image as a premium product.
The best defense is to make competitors realize that there will definitely be a costly and effective retaliation. Types of defensive moves are:
Disciplining: If a firm reacts firmly and specifically to a competitor move, this disciplining action sets the expectation that retaliation will always occur. The discipling action is effective when the retaliation is specific, and the signaling of being a response to competitor aggression is explicit. Generalized reactions are costly, ineffective, and run the risk of starting wars of attrition.
Denying a base: Moves like price cuts and aggressive marketing campaigns ensure that competitors don't meet their targets set for the aggressive move. While this may involve substantial short-term costs, it can cause the competitor to de-escalate.
Communicating commitment: This is a method of deterrence by making a firm's intentions clear to its competitors. Rivals will take that into consideration before executing it. The credibility of a commitment depends on the resources to carry out the commitment effectively, a history of credible commitments, and ability to demonstrate compliance with the commitment through metrics.
Structural Analysis can also explain why some firms consistently out-perform others within an industry and provide a framework for guiding competitive strategy. A Strategic Group is a set of firms that follow similar strategies, have similar market shares, and respond similarly to strategic events form a strategic group. The five competitive forces will have unequal impacts on different Strategic Groups. Formulation of competitive strategy boils down to choosing which Strategic Group to compete in or creating an entirely new strategic group.