Competitive Advantage by Michael Porter

Michael Porter’s book Competitive Advantage was maybe the first business book to make an impact on my work.  I had just started working at a small consulting company after studying civil engineering, so I was fairly clueless about business analysis.  I had read about his Five Forces framework, but it didn’t really impact my work that much, perhaps because it was so concerned with industries rather than individual companies.  It didn’t seem that relevant to my day-to-day work.  In Competitive Advantage, Porter lays out his theories on competitive strategy, (you guessed it) competitive advantage, using value chain analysis to understand those concepts, and a few related topics.  Unlike industry analysis, the value chain felt insightful and actionable.  Since then, I’ve used it often to evaluate clients’ strategies and to conduct competitive analysis.  I thought I’d repay my intellectual debt by devoting a few posts to really digging into Porter’s concepts, where they work, and where they sometimes fall short.

In this post, I’m going to focus on Porter’s concept of competitive advantage.  The real core of the book is understanding whether companies profit from creating value for customers, or whether that value is competed away.  Even most unprofitable companies create value for customers; otherwise, those customers wouldn’t buy from them.  But to get more than its fair share of profits, a company has to be able to do things that its competitors can’t – competitive advantage.  If your competitors can copy what you do, they will never allow you to eek out more than the bare minimum in profits.

Types of competitive advantage

There are only two (or maybe three) flavors of competitive advantage as far as Porter is concerned:  cost advantage and differentiation.  Cost advantage is like Highlander (“there can be only one!”);  you have to have lower costs than any other competitor.  That advantage allows you to either price your products lower than anyone else or just to match prices and take the difference in profits.  Wal-Mart is the classic example.  Differentiation just means meeting some customer need better than any competitor and getting a premium price in return.  Unlike cost advantage, there can be multiple firms in an industry that each have their own unique kind of differentiation.  In apparel, one jeans manufacturer like Seven for All Mankind might lay claim to the best fit, Diesel’s brand might appeal the most to young consumers, and True Religion might be the brand of choice for people looking for “Malibu hippy-bohemian chic” (actual phrase from their SEC filings!).  For this reason, differentiation is often far more attractive for companies than cost advantage because choosing contrasting bases of differentiation somewhat mitigates brutal, head-on competition (like airline price wars).  This also explains why industry profitability goes into the toilet when companies start copying each others’ strategies.

Being first to market, having a market share advantage, or having more financial resources do not translate directly into either of these advantages, necessarily.  The elusive third strategy is what he calls a focus strategy, where companies aim to serve a specific segment of a market rather than the entire market, thus achieving a cost or differentiation advantage in that segment that other companies can’t copy.  A focus/cost strategy might involve only selling high-volume orders to repeat customers, like IP does in paper products, to reduce costs, while green marketing like Method household products represents a focus/differentiation strategy where you sell only to environmentally conscious customers willing to pay a higher price.  But it still boils down to cost advantage or differentiation – focusing doesn’t get you anything unless you can achieve one of these goals.

One important aspect of competitive strategy that often gets overlooked is that even if a company adopts a cost or differentiation strategy, it must still be at parity or proximity to competitors on other factors.  A cost advantage is nullified if quality or service are perceived to be unacceptably bad, and differentiation is difficult to leverage if the company cannot be profitable at a price that customers will accept.

The worst place to be in Porter’s analysis is “stuck in the middle.”  You’re not the cost leader, and you’re not really differentiated.  You’re ok at a lot of things but don’t really have a calling card that will allow you to win against competitors.  Companies stuck in the middle can survive because of market inefficiencies, like uninformed customers or a local monopoly, but they never do well.

Competitive advantage in the real world?

In the real world, this competitive strategy theory doesn’t hold completely.  In the apparel market, for example, Wal-Mart is definitely the cost leader, while Target is slightly more expensive with a dash of differentiation based on design and branding.  Yet most people wouldn’t say Target’s products are really distinctive compared to the whole breadth of the clothing industry.  So can we really call them differentiated?  Porter might say Target is stuck in the middle.  And yet Target’s profit margins are as good or better than Wal-Mart’s in the past few years.  That doesn’t fit Porter’s theories unless you redefine the industry to consist of only discount retailers, where Target then assumes the position of the differentiated firm in the industry.  So just be aware that like many theories, Porter’s theory of competitive strategy is a bit oversimplified.  In reality, every industry breaks down into a million possible segments, and almost no competitor truly addresses the entire market.  Competitive advantage often comes from discovering or addressing some novel new segment, not necessarily traditional cost or differentiation advantages across the entire market.

More posts in the series

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  • Swaibu Karegyeya

    You gave nice facts about porter m.keep it up. Swaibu K(Uganda)

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