Michael Porter's Five Forces - iut.ac.irivut.iut.ac.ir/content/131/files/Michael_Porters_Five_Forces.pdf · Michael Porter's Five Forces Porter's Five Forces Assessing the Balance

Michael Porter's Five Forces

Porter's Five Forces

Assessing the Balance of Power in a Business Situation

Why use the tool?

The Porter’s Five Forces tool is a simple but powerful tool for understanding where power lies in a business situation. This is useful, because it helps you understand both the strength of your current competitive position, and the strength of a position you’re looking to move into.

With a clear understanding of where power lies, you can take fair advantage of a situation of strength, improve a situation of weakness, and avoid taking wrong steps. This makes it an important part of your planning toolkit.

Conventionally, the tool is used to identify whether new products, services or businesses have the potential to be profitable. However it can be very illuminating when used to understand the balance of power in other situations.

How to use the tool:

Five Forces Analysis assumes that there are five important forces that determine competitive power in a situation. These are:-

Supplier Power: Here you assess how easy it is for suppliers to drive up prices. This is driven by the number of suppliers of each key input, the uniqueness of their product or service, their strength and control over you, the cost of switching from one to another, and so on. The fewer the supplier choices you have, and the more you need suppliers' help, the more powerful your suppliers are.

Buyer Power: Here you ask yourself how easy it is for buyers to drive prices down. Again, this is driven by the number of buyers, the importance of each individual buyer to your business, the cost to them of switching from your products and services to those of someone else, and so on. If you deal with few, powerful buyers, they are often able to dictate terms to you.

Competitive Rivalry: What is important here is the number and capability of your competitors – if you have many competitors, and they offer equally attractive products and services, then you’ll most likely have little power in the situation. If suppliers and buyers don’t get a good deal from you, they’ll go elsewhere. On the other hand, if no-one else can do what you do, then you can often have tremendous strength.

Threat of Substitution: This is affected by the ability of your customers to find a different way of doing what you do – for example, if you supply a unique software product that automates an

4.

3.

2.

1.

Page 1


important process, people may substitute by doing the process manually or by outsourcing it. If substitution is easy and substitution is viable, then this weakens your power.

Threat of New Entry: Power is also affected by the ability of people to enter your market. If it costs little in time or money to enter your market and compete effectively, if there are few economies of scale in place, or if you have little protection for your key technologies, then new competitors can quickly enter your market and weaken your position. If you have strong and durable barriers to entry, then you can preserve a favorable position and take fair advantage of it.

These forces can be neatly brought together in a diagram like the one below:

To use the tool to understand your situation, look at each of these forces one-by-one.

Brainstorm the relevant factors for your market or situation, and then check against the factors listed for the force in the diagram above.

5.

Page 2


Then mark the key factors on a diagram like the one above, and summarize the size and scale of the force on the diagram. An easy way of doing this is to use, for example, a single “+” sign for a force moderately in your favor, or “--" for a force strongly against you (you can see this in the example below).

Then look at the situation you find using this analysis and think through how it affects you. Bear in mind that few situations are perfect; however use this as a framework for thinking through what you could change to increase your power with respect to each force.

Example:Martin Johnson is deciding whether to switch career and become a farmer – he’s always loved the countryside, and wants to switch to a career where he’s his own boss. He creates the following Five Forces Analysis as he thinks the situation through:

This tool was created by Harvard Business School professor, Michael Porter, to analyze the attractiveness and likely-profitability of an industry. Since publication, it has become one of the most important business strategy tools. The classic article which introduces it is “How Competitive Forces Shape Strategy” in Harvard Business Review 57, March – April 1979, pages 86-93.

Page 3


This worries him:

The threat of new entry is quite high: if anyone looks as if they’re making a sustained profit, new competitors can come into the industry easily, reducing profits; Competitive rivalry is extremely high: if someone raises prices, they’ll be quickly undercut. Intense competition puts strong downward pressure on prices; Buyer Power is strong, again implying strong downward pressure on prices; and There is some threat of substitution.

Unless he is able to find some way of changing this situation, this looks like a very tough industry to survive in. Maybe he’ll need to specialize in a sector of the market that’s protected from some of these forces, or find a related business that’s in a stronger position.

Key points:

Page 4


Porter’s Five Forces Analysis is an important tool for assessing the potential for profitability in an industry. With a little adaptation, it is also useful as a way of assessing the balance of power in more general situations.

It works by looking at the strength of five important forces that affect competition:

Supplier Power: The power of suppliers to drive up the prices of your inputs; Buyer Power: The power of your customers to drive down your prices; Competitive Rivalry: The strength of competition in the industry; The Threat of Substitution: The extent to which different products and services can be used in place of your own; and The Threat of New Entry: The ease with which new competitors can enter the market if they see that you are making good profits (and then drive your prices down).

By thinking through how each force affects you, and by identifying the strength and direction of each force, you can quickly assess the strength of the position and your ability to make a sustained profit in the industry.

You can then look at how you can affect each of the forces to move the balance of power more in your favor.

Porter's Five Forces

A MODEL FOR INDUSTRY ANALYSIS

The model of pure competition implies that risk-adjusted rates of return should be constant across firms and industries. However, numerous economic studies have affirmed that different industries can sustain different levels of profitability; part of this difference is explained by industry structure.

Michael Porter provided a framework that models an industry as being influenced by five forces. The strategic business manager seeking to develop an edge over rival firms can use this model to better understand the industry context in which the firm operates.

Diagram of Porter's 5 Forces

Page 5


I. Rivalry

In the traditional economic model, competition among rival firms drives profits to zero. But competition is not perfect and firms are not unsophisticated passive price takers. Rather, firms strive for a competitive advantage over their rivals. The intensity of rivalry among firms varies across industries, and strategic analysts are interested in these differences.

Economists measure rivalry by indicators of industry concentration. The Concentration Ratio (CR) is one such measure. The Bureau of Census periodically reports the CR for major Standard Industrial Classifications (SIC's). The CR indicates the percent of market share held by the four largest firms (CR's for the largest 8, 25, and 50 firms in an industry also are available). A high concentration ratio indicates that a high

SUPPLIER POWER Supplier concentration

Importance of volume to supplier Differentiation of inputs

Impact of inputs on cost or differentiation Switching costs of firms in the industry

Presence of substitute inputs Threat of forward integration

Cost relative to total purchases in industry

BARRIERSTO ENTRY

Absolute cost advantages Proprietary learning curve

Access to inputs Government policy

Economies of scale Capital requirements

Brand identity Switching costs

Access to distribution Expected retaliation Proprietary products

THREAT OFSUBSTITUTES -Switching costs -Buyer inclination to substitute -Price-performance trade-off of substitutes

BUYER POWER Bargaining leverage

Buyer volume Buyer information

Brand identity Price sensitivity

Threat of backward integration Product differentiation

Buyer concentration vs. industry Substitutes available

Buyers' incentives

DEGREE OF RIVALRY -Exit barriers -Industry concentration -Fixed costs/Value added -Industry growth -Intermittent overcapacity -Product differences -Switching costs -Brand identity -Diversity of rivals -Corporate stakes

Page 6

Michael Porter's Five Forcesy ) g g

concentration of market share is held by the largest firms - the industry is concentrated. With only a few firms holding a large market share, the competitive landscape is less competitive (closer to a monopoly). A low concentration ratio indicates that the industry is characterized by many rivals, none of which has a significant market share. These fragmented markets are said to be competitive. The concentration ratio is not the only available measure; the trend is to define industries in terms that convey more information than distribution of market share.

If rivalry among firms in an industry is low, the industry is considered to be disciplined. This discipline may result from the industry's history of competition, the role of a leading firm, or informal compliance with a generally understood code of conduct. Explicit collusion generally is illegal and not an option; in low-rivalry industries competitive moves must be constrained informally. However, a maverick firm seeking a competitive advantage can displace the otherwise disciplined market.

When a rival acts in a way that elicits a counter-response by other firms, rivalry intensifies. The intensity of rivalry commonly is referred to as being cutthroat, intense, moderate, or weak, based on the firms' aggressiveness in attempting to gain an advantage.

In pursuing an advantage over its rivals, a firm can choose from several competitive moves:

Changing prices - raising or lowering prices to gain a temporary advantage. Improving product differentiation - improving features, implementing innovations in the manufacturing process and in the product itself. Creatively using channels of distribution - using vertical integration or using a distribution channel that is novel to the industry. For example, with high-end jewelry stores reluctant to carry its watches, Timex moved into drugstores and other non-traditional outlets and cornered the low to mid-price watch market. Exploiting relationships with suppliers - for example, from the 1950's to the 1970's Sears, Roebuck and Co. dominated the retail household appliance market. Sears set high quality standards and required suppliers to meet its demands for product specifications and price.

The intensity of rivalry is influenced by the following industry characteristics:

A larger number of firms increases rivalry because more firms must compete for the same customers and resources. The rivalry intensifies if the firms have similar market share, leading to a struggle for market leadership. Slow market growth causes firms to fight for market share. In a growing market, firms are able to improve revenues simply because of the expanding market. High fixed costs result in an economy of scale effect that increases rivalry.When total costs are mostly fixed costs, the firm must produce near capacity to attain the lowest unit costs. Since the firm must sell this large quantity of product, high levels of production lead to a fight for market share and results in increased

3.

2.

1.

Page 7


rivalry.High storage costs or highly perishable products cause a producer to sell goods as soon as possible. If other producers are attempting to unload at the same time, competition for customers intensifies.Low switching costs increases rivalry. When a customer can freely switch from one product to another there is a greater struggle to capture customers. Low levels of product differentiation is associated with higher levels of rivalry.Brand identification, on the other hand, tends to constrain rivalry. Strategic stakes are high when a firm is losing market position or has potential for great gains. This intensifies rivalry.High exit barriers place a high cost on abandoning the product. The firm must compete. High exit barriers cause a firm to remain in an industry, even when the venture is not profitable. A common exit barrier is asset specificity. When the plant and equipment required for manufacturing a product is highly specialized, these assets cannot easily be sold to other buyers in another industry. Litton Industries' acquisition of Ingalls Shipbuilding facilities illustrates this concept. Litton was successful in the 1960's with its contracts to build Navy ships. But when the Vietnam war ended, defense spending declined and Litton saw a sudden decline in its earnings. As the firm restructured, divesting from the shipbuilding plant was not feasible since such a large and highly specialized investment could not be sold easily, and Litton was forced to stay in a declining shipbuilding market. A diversity of rivals with different cultures, histories, and philosophies make an industry unstable. There is greater possibility for mavericks and for misjudging rival's moves. Rivalry is volatile and can be intense. The hospital industry, for example, is populated by hospitals that historically are community or charitable institutions, by hospitals that are associated with religious organizations or universities, and by hospitals that are for-profit enterprises. This mix of philosophies about mission has lead occasionally to fierce local struggles by hospitals over who will get expensive diagnostic and therapeutic services. At other times, local hospitals are highly cooperative with one another on issues such as community disaster planning. Industry Shakeout. A growing market and the potential for high profits induces new firms to enter a market and incumbent firms to increase production. A point is reached where the industry becomes crowded with competitors, and demand cannot support the new entrants and the resulting increased supply. The industry may become crowded if its growth rate slows and the market becomes saturated, creating a situation of excess capacity with too many goods chasing too few buyers. A shakeout ensues, with intense competition, price wars, and company failures.

BCG founder Bruce Henderson generalized this observation as the Rule of Three and Four: a stable market will not have more than three significant competitors, and the largest competitor will have no more than four times the market share of the smallest. If this rule is true, it implies that:

If there is a larger number of competitors, a shakeout is inevitable

10.

9.

8.

7.

6.

5.

4.

Page 8


If there is a larger number of competitors, a shakeout is inevitable Surviving rivals will have to grow faster than the market Eventual losers will have a negative cash flow if they attempt to grow All except the two largest rivals will be losers The definition of what constitutes the "market" is strategically important.

Whatever the merits of this rule for stable markets, it is clear that market stability and changes in supply and demand affect rivalry. Cyclical demand tends to create cutthroat competition. This is true in the disposable diaper industry in which demand fluctuates with birth rates, and in the greeting card industry in which there are more predictable business cycles.

II. Threat Of Substitutes

In Porter's model, substitute products refer to products in other industries. To the economist, a threat of substitutes exists when a product's demand is affected by the price change of a substitute product. A product's price elasticity is affected by substitute products - as more substitutes become available, the demand becomes more elastic since customers have more alternatives. A close substitute product constrains the ability of firms in an industry to raise prices.

The competition engendered by a Threat of Substitute comes from products outside the industry. The price of aluminum beverage cans is constrained by the price of glass bottles, steel cans, and plastic containers. These containers are substitutes, yet they are not rivals in the aluminum can industry. To the manufacturer of automobile tires, tire retreads are a substitute. Today, new tires are not so expensive that car owners give much consideration to retreading old tires. But in the trucking industry new tires are expensive and tires must be replaced often. In the truck tire market, retreading remains a viable substitute industry. In the disposable diaper industry, cloth diapers are a substitute and their prices constrain the price of disposables.

While the treat of substitutes typically impacts an industry through price competition, there can be other concerns in assessing the threat of substitutes. Consider the substitutability of different types of TV transmission: local station transmission to home TV antennas via the airways versus transmission via cable, satellite, and telephone lines. The new technologies available and the changing structure of the entertainment media are contributing to competition among these substitute means of connecting the home to entertainment. Except in remote areas it is unlikely that cable TV could compete with free TV from an aerial without the greater diversity of entertainment that it affords the customer.

III. Buyer Power

The power of buyers is the impact that customers have on a producing industry. In Page 9


The power of buyers is the impact that customers have on a producing industry. In general, when buyer power is strong, the relationship to the producing industry is near to what an economist terms a monopsony - a market in which there are many suppliers and one buyer. Under such market conditions, the buyer sets the price. In reality few pure monopsonies exist, but frequently there is some asymmetry between a producing industry and buyers. The following tables outline some factors that determine buyer power.

IV. Supplier Power

A producing industry requires raw materials - labor, components, and other supplies. This requirement leads to buyer-supplier relationships between the industry and the firms that provide it the raw materials used to create products. Suppliers, if powerful, can exert an influence on the producing industry, such as selling raw materials at a high price to capture some of the industry's profits. The following tables outline some factors that determine supplier power.

Buyers are Powerful if: Example

Buyers are concentrated - there are a few buyers with significant market share DOD purchases from defense contractors

Buyers purchase a significant proportion of output - distribution of purchases or if the product is standardized

Circuit City and Sears' large retail market provides power over appliance manufacturers

Buyers possess a credible backward integration threat - can threaten to buy producing firm or rival Large auto manufacturers' purchases of tires

Buyers are Weak if: Example

Producers threaten forward integration - producer can take over own distribution/retailing

Movie-producing companies have integrated forward to acquire theaters

Significant buyer switching costs - products not standardized and buyer cannot easily switch to another product

IBM's 360 system strategy in the 1960's

Buyers are fragmented (many, different) - no buyer has any particular influence on product or price Most consumer products

Producers supply critical portions of buyers' input - distribution of purchases Intel's relationship with PC manufacturers

Suppliers are Powerful if: ExamplePage 10


V. Barriers to Entry / Threat of Entry

It is not only incumbent rivals that pose a threat to firms in an industry; the possibility that new firms may enter the industry also affects competition. In theory, any firm should be able to enter and exit a market, and if free entry and exit exists, then profits always should be nominal. In reality, however, industries possess characteristics that protect the high profit levels of firms in the market and inhibit additional rivals from entering the market. These are barriers to entry.

Barriers to entry are more than the normal equilibrium adjustments that markets typically make. For example, when industry profits increase, we would expect additional firms to enter the market to take advantage of the high profit levels, over time driving down profits for all firms in the industry. When profits decrease, we would expect some firms to exit the market thus restoring a market equilibrium. Falling prices, or the expectation that future prices will fall, deters rivals from entering a market. Firms also may be reluctant to enter markets that are extremely uncertain, especially if entering involves expensive start-up costs. These are normal accommodations to market conditions. But if firms individually (collective action would be illegal collusion) keep prices artificially low as a strategy to prevent potential entrants from entering the market, such entry-deterring pricing establishes a barrier.

Suppliers are Powerful if: Example

Credible forward integration threat by suppliers Baxter International, manufacturer of hospital supplies, acquired American Hospital Supply, a distributor

Suppliers concentrated Drug industry's relationship to hospitals

Significant cost to switch suppliers Microsoft's relationship with PC manufacturers

Customers Powerful Boycott of grocery stores selling non-union picked grapes

Suppliers are Weak if: Example

Many competitive suppliers - product is standardized

Tire industry relationship to automobile manufacturers

Purchase commodity products Grocery store brand label products

Credible backward integration threat by purchasers Timber producers relationship to paper companies

Concentrated purchasers Garment industry relationship to major department stores

Customers Weak Travel agents' relationship to airlines

Page 11


Barriers to entry are unique industry characteristics that define the industry. Barriers reduce the rate of entry of new firms, thus maintaining a level of profits for those already in the industry. From a strategic perspective, barriers can be created or exploited to enhance a firm's competitive advantage. Barriers to entry arise from several sources:

Government creates barriers. Although the principal role of the government in a market is to preserve competition through anti-trust actions, government also restricts competition through the granting of monopolies and through regulation. Industries such as utilities are considered natural monopolies because it has been more efficient to have one electric company provide power to a locality than to permit many electric companies to compete in a local market. To restrain utilities from exploiting this advantage, government permits a monopoly, but regulates the industry. Illustrative of this kind of barrier to entry is the local cable company. The franchise to a cable provider may be granted by competitive bidding, but once the franchise is awarded by a community a monopoly is created. Local governments were not effective in monitoring price gouging by cable operators, so the federal government has enacted legislation to review and restrict prices.

The regulatory authority of the government in restricting competition is historically evident in the banking industry. Until the 1970's, the markets that banks could enter were limited by state governments. As a result, most banks were local commercial and retail banking facilities. Banks competed through strategies that emphasized simple marketing devices such as awarding toasters to new customers for opening a checking account. When banks were deregulated, banks were permitted to cross state boundaries and expand their markets. Deregulation of banks intensified rivalry and created uncertainty for banks as they attempted to maintain market share. In the late 1970's, the strategy of banks shifted from simple marketing tactics to mergers and geographic expansion as rivals attempted to expand markets. Patents and proprietary knowledge serve to restrict entry into an industry. Ideas and knowledge that provide competitive advantages are treated as private property when patented, preventing others from using the knowledge and thus creating a barrier to entry. Edwin Land introduced the Polaroid camera in 1947 and held a monopoly in the instant photography industry. In 1975, Kodak attempted to enter the instant camera market and sold a comparable camera. Polaroid sued for patent infringement and won, keeping Kodak out of the instant camera industry. Asset specificity inhibits entry into an industry. Asset specificity is the extent to which the firm's assets can be utilized to produce a different product. When an industry requires highly specialized technology or plants and equipment, potential entrants are reluctant to commit to acquiring specialized assets that cannot be sold or converted into other uses if the venture fails. Asset specificity provides a barrier to entry for two reasons: First, when firms already hold specialized assets they fiercely resist efforts by others from taking their market share. New entrants

3.

2.

1.

Page 12


they fiercely resist efforts by others from taking their market share. New entrants can anticipate aggressive rivalry. For example, Kodak had much capital invested in its photographic equipment business and aggressively resisted efforts by Fuji to intrude in its market. These assets are both large and industry specific. The second reason is that potential entrants are reluctant to make investments in highly specialized assets. Organizational (Internal) Economies of Scale. The most cost efficient level of production is termed Minimum Efficient Scale (MES). This is the point at which unit costs for production are at minimum - i.e., the most cost efficient level of production. If MES for firms in an industry is known, then we can determine the amount of market share necessary for low cost entry or cost parity with rivals. For example, in long distance communications roughly 10% of the market is necessary for MES. If sales for a long distance operator fail to reach 10% of the market, the firm is not competitive.

The existence of such an economy of scale creates a barrier to entry. The greater the difference between industry MES and entry unit costs, the greater the barrier to entry. So industries with high MES deter entry of small, start-up businesses. To operate at less than MES there must be a consideration that permits the firm to sell at a premium price - such as product differentiation or local monopoly.

Barriers to exit work similarly to barriers to entry. Exit barriers limit the ability of a firm to leave the market and can exacerbate rivalry - unable to leave the industry, a firm must compete. Some of an industry's entry and exit barriers can be summarized as follows:

Easy to Enter if there is:

Common technology Little brand franchise Access to distribution channels Low scale threshold

Difficult to Enter if there is:

Patented or proprietary know-how Difficulty in brand switching Restricted distribution channels High scale threshold

Easy to Exit if there are:

Salable assets Low exit costs Independent businesses

Difficult to Exit if there are:

Specialized assets High exit costs Interrelated businesses

4.

Page 13


DYNAMIC NATURE OF INDUSTRY RIVALRY

Our descriptive and analytic models of industry tend to examine the industry at a given state. The nature and fascination of business is that it is not static. While we are prone to generalize, for example, list GM, Ford, and Chrysler as the "Big 3" and assume their dominance, we also have seen the automobile industry change. Currently, the entertainment and communications industries are in flux. Phone companies, computer firms, and entertainment are merging and forming strategic alliances that re-map the information terrain. Schumpeter and, more recently, Porter have attempted to move the understanding of industry competition from a static economic or industry organization model to an emphasis on the interdependence of forces as dynamic, or punctuated equilibrium, as Porter terms it.

In Schumpeter's and Porter's view the dynamism of markets is driven by innovation. We can envision these forces at work as we examine the following changes:

Top 10 US Industrial Firms by Sales 1917 - 1988

10 Largest US Firms by Assets, 1909 and 1987

1917 1945 1966 1983 1988 1 US Steel General Motors General Motors Exxon General Motors

2 Swift US Steel Ford General Motors Ford

3 Armour Standard Oil -NJ

Standard Oil -NJ (Exxon) Mobil Exxon

4 American Smelting US Steel General Electric Texaco IBM

5 Standard Oil -NJ Bethlehem Steel Chrysler Ford General

Electric

6 Bethlehem Steel Swift Mobil IBM Mobil

7 Ford Armour Texaco Socal (Oil) Chrysler

8 DuPont Curtiss-Wright US Steel DuPont Texaco

9 American Sugar Chrysler IBM Gulf Oil DuPont

10 General Electric Ford Gulf Oil Standard Oil of Indiana Philip Morris

1909 1987

1 US STEEL GM (Not listed in 1909)

Page 14


GENERIC STRATEGIES TO COUNTER THE FIVE FORCES

Strategy can be formulated on three levels:

corporate level business unit level functional or departmental level.

The business unit level is the primary context of industry rivalry. Michael Porter identified three generic strategies (cost leadership, differentiation, and focus) that can be implemented at the business unit level to create a competitive advantage. The proper generic strategy will position the firm to leverage its strengths and defend against the adverse effects of the five forces.

Michael Porter's Big Ideas The world's most famous business-school professor is fed up with CEOs who claim that the world changes too fast for their companies to have a long-term strategy. If you want to make a difference as a leader, you've got to make time for strategy.

2 STANDARD OIL, NJ (Now, EXXON #3) SEARS (1909 = 45)

3 AMERICAN TOBACCO (Now, American Brands #52) EXXON (Standard Oil trust broken up in 1911)

4 AMERICAN MERCANTILE MARINE (Renamed US Lines; acquired by Kidde, Inc., 1969; sold to McLean Industries, 1978; bankruptcy, 1986 IBM (Ranked 68, 1948)

5 INTERNATIONAL HARVESTER (Renamed Navistar #182); divested farm equipment FORD (Listed in 1919)

6 ANACONDA COPPER (acquired by ARCO in 1977) MOBIL OIL

7 US LEATHER (Liquidated in 1935) GENERAL ELECTRIC (1909= 16)

8 ARMOUR (Merged in 1968 with General Host; in 1969 by Greyhound; 1983 sold to ConAgra)

CHEVRON (Not listed in 1909)

9 AMERICAN SUGAR REFINING (Renamed AMSTAR. In 1967 =320) Leveraged buyout and sold in pieces) TEXACO (1909= 91)

10 PULLMAN, INC (Acquired by Wheelabrator Frye, 1980; spun-off as Pullman-Peabody, 1981; 1984 sold to Trinity Industries) DU PONT (1909= 29)

Page 15

Michael Porter's Five Forces, y g gy.

Here is how Michael E. Porter regards the business landscape: Beginning in the mid-1980s, he more or less left the strategy world to its own devices, focusing his attention instead on the question of international competitiveness. He advised foreign governments on their economic policies and headed a U.S. presidential commission. He wrote books and papers on industry dynamics -- from ceramics manufacturing in Italy to the robotics sector in Japan. He spoke everywhere. He was consumed by understanding the competitive advantage of nations.

Then, in the mid-1990s, he resurfaced. "I was reading articles about corporate strategy, too many of which began with 'Porter said . . . and that's wrong.' " Strategy had lost its intellectual currency. It was losing adherents. "People were being tricked and misled by other ideas," he says.

Like a domineering parent, Porter seems both miffed by the betrayal and pleased by his apparent indispensability. I can't turn my back for five minutes. Well, kids, the man is back. Porter seeks to return strategy to its place atop the executive pyramid.

Business strategy probably predates Michael Porter. Probably. But today, it is hard to imagine confronting the discipline without reckoning with the Harvard Business School professor, perhaps the world's best-known business academic. His first book, Competitive Strategy: Techniques for Analyzing Industries and Competitors (Free Press, 1980), is in its 53rd printing and has been translated into 17 languages. For years, excerpts from that and other Porter works have been required reading in "Competition and Strategy," the first-year course that every Harvard MBA student must take. Porter's strategy frameworks have suffered some ambivalence over the years in academic circles -- yet they have proved wildly compelling among business leaders around the world.

This is the paradox that Porter faces. His notions on strategy are more widely disseminated than ever and are preached at business schools and in seminars around the globe. Yet the idea of strategy itself has, in fact, taken a backseat to newfangled notions about competition hatched during the Internet frenzy: Who needs a long-term strategy when everyone's goal is simply to "get big fast"?

With his research group, Porter operates from a suite of offices tucked into a corner of Harvard Business School's main classroom building. At 53, his blond hair graying, he is no longer the wunderkind who, in his early thirties, changed the way CEOs thought about their companies and industries. Yet he's no less passionate about his pursuit -- and no less certain of his ability. In a series of interviews, Porter told Fast Company why strategy still matters.

Business keeps moving faster -- but you better make time for strategy.

It's been a bad decade for strategy. Companies have bought into an extraordinary number of flawed or simplistic ideas about competition -- what I call "intellectual potholes." As a result, many have abandoned strategy almost completely. Executives won't say that, of course. They say, "We have a strategy." But typically, their "strategy" is to produce the highest-quality products at the lowest cost or to consolidate their industry. They're just trying to improve on best practices. That's not a strategy.

Strategy has suffered for three reasons. First, in the 1970s and 1980s, people tried strategy, and they had problems with it. It was difficult. It seemed an artificial exercise. Second, and at the same time, the

Page 16


ascendance of Japan really riveted attention on implementation. People argued that strategy wasn't what was really important -- you just had to produce a higher-quality product than your rival, at a lower cost, and then improve that product relentlessly.

The third reason was the emergence of the notion that in a world of change, you really shouldn't have a strategy. There was a real drumbeat that business was about change and speed and being dynamic and reinventing yourself, that things were moving so fast, you couldn't afford to pause. If you had a strategy, it was rigid and inflexible. And it was outdated by the time you produced it.

That view set up a straw man, and it was a ridiculous straw man. It reflects a deeply flawed view of competition. But that view has become very well entrenched.

The irony, of course, is that when we look at the companies that we agree are successful, we also agree that they all clearly do have strategies. Look at Dell, or Intel, or Wal-Mart. We all agree that change is faster now than it was 10 or 15 years ago. Does that mean you shouldn't have a direction? Well, probably not. For a variety of reasons, though, lots of companies got very confused about strategy and how to think about it.

Of course strategy is hard -- it's about making tough choices.

There's a fundamental distinction between strategy and operational effectiveness. Strategy is about making choices, trade-offs; it's about deliberately choosing to be different. Operational effectiveness is about things that you really shouldn't have to make choices on; it's about what's good for everybody and about what every business should be doing.

Lately, leaders have tended to dwell on operational effectiveness. Again, this has been fed by the business literature: the ideas that emerged in the late 1980s and early 1990s, such as total quality, just-in-time, and reengineering. All were focused on the nitty-gritty of getting a company to be more effective. And for a while, some Japanese companies turned the nitty-gritty into an art form. They were incredibly competitive.

Japan's obsession with operational effectiveness became a huge problem, though, because only strategy can create sustainable advantage. And strategy must start with a different value proposition. A strategy delineates a territory in which a company seeks to be unique. Strategy 101 is about choices: You can't be all things to all people.

The essence of strategy is that you must set limits on what you're trying to accomplish. The company without a strategy is willing to try anything. If all you're trying to do is essentially the same thing as your rivals, then it's unlikely that you'll be very successful. It's incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long. That's especially true today, when the flow of information and capital is incredibly fast. It's extremely dangerous to bet on the incompetence of your competitors -- and that's what you're doing when you're competing on operational effectiveness.

What's worse, a focus on operational effectiveness alone tends to create a mutually destructive form of competition. If everyone's trying to get to the same place, then, almost inevitably, that causes

Page 17


customers to choose on price. This is a bit of a metaphor for the past five years, when we've seen widespread cratering of prices.

There have been those who argue that in this new millennium, with all of this change and new information, such a form of destructive competition is simply the way competition has to be. I believe very strongly that that is not the case. There are many opportunities for strategic differences in nearly every industry; the more dynamism there is in an economy, in fact, the greater the opportunity. And a much more positive kind of competition could emerge if managers thought about strategy in the right way.

Technology changes, strategy doesn't.

The underlying principles of strategy are enduring, regardless of technology or the pace of change. Consider the Internet. Whether you're on the Net or not, your profitability is still determined by the structure of your industry. If there are no barriers to entry, if customers have all the power, and if rivalry is based on price, then the Net doesn't matter -- you won't be very profitable.

Sound strategy starts with having the right goal. And I argue that the only goal that can support a sound strategy is superior profitability. If you don't start with that goal and seek it pretty directly, you will quickly be led to actions that will undermine strategy. If your goal is anything but profitability -- if it's to be big, or to grow fast, or to become a technology leader -- you'll hit problems.

Finally, strategy must have continuity. It can't be constantly reinvented. Strategy is about the basic value you're trying to deliver to customers, and about which customers you're trying to serve. That positioning, at that level, is where continuity needs to be strongest. Otherwise, it's hard for your organization to grasp what the strategy is. And it's hard for customers to know what you stand for.

Strategy hasn't changed, but change has.

On the other hand, I agree that the half-life of everything has shortened. So setting strategy has become a little more complicated. In the old days, maybe 20 years ago, you could set a direction for your business, define a value proposition, then lumber along pursuing that. Today, you still need to define how you're going to be distinctive. But we know that simply making that set of choices will not protect you unless you're constantly sucking in all of the available means to improve on your ability to deliver.

So companies have to be very schizophrenic. On one hand, they have to maintain continuity of strategy. But they also have to be good at continuously improving. Southwest Airlines, for example, has focused on a strategy of serving price-minded customers who want to go from place to place on relatively short, frequently offered flights without much service. That has stayed consistent over the years. But Southwest has been extremely aggressive about assimilating every new idea possible to deliver on that strategy. Today, it does many things differently than it did 30 years ago -- but it's still serving essentially the same customers who have essentially the same needs.

The error that some managers make is that they see all of the change and all of the new technology out there, and they say, "God, I've just got to get out there and implement like hell." They forget that if

d 't have a direction, if you don't have something distinctive at the end of the day, it's going to Page 18


you don't have a direction, if you don't have something distinctive at the end of the day, it's going to be very hard to win. They don't understand that you need to balance the internal juxtaposition of change and continuity.

The thing is, continuity of strategic direction and continuous improvement in how you do things are absolutely consistent with each other. In fact, they're mutually reinforcing. The ability to change constantly and effectively is made easier by high-level continuity. If you've spent 10 years being the best at something, you're better able to assimilate new technologies. The more explicit you are about setting strategy, about wrestling with trade-offs, the better you can identify new opportunities that support your value proposition. Otherwise, sorting out what's important among a bewildering array of technologies is very difficult. Some managers think, "The world is changing, things are going faster -- so I've got to move faster. Having a strategy seems to slow me down." I argue no, no, no -- having a strategy actually speeds you up.

Beware the myth of inflection points.

The catch is this: Sometimes the environment or the needs of customers do shift far enough so that continuity doesn't work anymore, so that your essential positioning is no longer valid. But those moments occur very infrequently for most companies. Intel's Andy Grove talks about inflection points that force you to revisit your core strategy. The thing is, inflection points are very rare. What managers have done lately is assume that they are everywhere, that disruptive technologies are everywhere.

Discontinuous change, in other words, is not as pervasive as we think. It's not that it doesn't exist. Disruptive technologies do exist, and their threat has to be on everyone's mind. But words like "transformation" and "revolution" are incredibly overused. We're always asking the companies we work with, "Where is that new technology that's going to change everything?" For every time that a new technology is out there, there are 10 times that one is not.

Let's look again at the Internet. In Fast Company two years ago, we would have read that the Internet was an incredibly disruptive technology, that industry after industry was going to be transformed. Well, guess what? It's not an incredibly disruptive technology for all parts of the value chain. In many cases, Internet technology is actually complementary to traditional technologies. What we're seeing is that the companies winning on the Internet use the new technology to leverage their existing strategy.

Great strategists get a few (big) things right.

Change brings opportunities. On the other hand, change can be confusing. One school of thought says that it's all just too complicated, that no manager can ever solve the complex problem that represents a firmwide strategy today. So managers should use the hunt-and-peck method of finding a strategy: Try something, see if it works, then proceed to the next. It's basically just a succession of incremental experiments.

I say that method will rarely work, because the essence of strategy is choice and trade-offs and fit. What makes Southwest Airlines so successful is not a bunch of separate things, but rather the strategy that ties everything together. If you were to experiment with onboard service, then with gate service, then with ticketing mechanisms, all separately, you'd never get to Southwest's strategy.

Page 19


You can see why we're in the mess that we're in. Competition is subtle, and managers are prone to simplify. What we learn from looking at actual competition is that winning companies are anything but simple. Strategy is complex. The good news is that even successful companies almost never get everything right up front. When the Vanguard Group started competing in mutual funds, there was no Internet, no index funds. But Vanguard had an idea that if it could strip costs to the bone and keep fees low -- and not try to beat the market by taking on risk -- it would win over time. John Bogle understood the essence of that, and he took advantage of incremental opportunities over time.

You don't have to have all the answers up front. Most successful companies get two or three or four of the pieces right at the start, and then they elucidate their strategy over time. It's the kernel of things that they saw up front that is essential. That's the antidote to complexity.

Great strategies are a cause.

The chief strategist of an organization has to be the leader -- the CEO. A lot of business thinking has stressed the notion of empowerment, of pushing down and getting a lot of people involved. That's very important, but empowerment and involvement don't apply to the ultimate act of choice. To be successful, an organization must have a very strong leader who's willing to make choices and define the trade-offs. I've found that there's a striking relationship between really good strategies and really strong leaders.

That doesn't mean that leaders have to invent strategy. At some point in every organization, there has to be a fundamental act of creativity where someone divines the new activity that no one else is doing. Some leaders are really good at that, but that ability is not universal. The more critical job for a leader is to provide the discipline and the glue that keep such a unique position sustained over time.

Another way to look at it is that the leader has to be the guardian of trade-offs. In any organization, thousands of ideas pour in every day -- from employees with suggestions, from customers asking for things, from suppliers trying to sell things. There's all this input, and 99% of it is inconsistent with the organization's strategy.

Great leaders are able to enforce the trade-offs: "Yes, it would be great if we could offer meals on Southwest Airlines, but if we did that, it wouldn't fit our low-cost strategy. Plus, it would make us look like United, and United is just as good as we are at serving meals." At the same time, great leaders understand that there's nothing rigid or passive about strategy -- it's something that a company is continually getting better at -- so they can create a sense of urgency and progress while adhering to a clear and very sustained direction.

A leader also has to make sure that everyone understands the strategy. Strategy used to be thought of as some mystical vision that only the people at the top understood. But that violated the most fundamental purpose of a strategy, which is to inform each of the many thousands of things that get done in an organization every day, and to make sure that those things are all aligned in the same basic direction.

If people in the organization don't understand how a company is supposed to be different, how it creates value compared to its rivals, then how can they possibly make all of the myriad choices they

Page 20

Michael Porter's Five Forcescreates value compared to its rivals, then how can they possibly make all of the myriad choices they have to make? Every salesman has to know the strategy -- otherwise, he won't know who to call on. Every engineer has to understand it, or she won't know what to build.

The best CEOs I know are teachers, and at the core of what they teach is strategy. They go out to employees, to suppliers, and to customers, and they repeat, "This is what we stand for, this is what we stand for." So everyone understands it. This is what leaders do. In great companies, strategy becomes a cause. That's because a strategy is about being different. So if you have a really great strategy, people are fired up: "We're not just another airline. We're bringing something new to the world."

Page 21

Documents

Michael Porter's Five Forces - iut.ac.irivut.iut.ac.ir/content/131/files/Michael_Porters_Five_Forces.pdf · Michael Porter's Five Forces Porter's Five Forces Assessing the Balance