Competitive Advantage by Michael Porter, Part 2

I recently wrote about Michael Porter’s concept of competitive advantage, and now I’d like to start really drilling down into the value chain analysis he uses to diagnose competitive advantage.  A value chain analysis disaggregates a company into its activities, grouped by function, to understand how different activities contribute to or detract from competitive advantage.  The analysis assesses both each individual activity and also how they are linked and configured.  Often, it’s the connections between activities that provide the greatest advantage and are the hardest for competitors to imitate, rather than just a handful of specific processes.

To bring the value chain to life, I thought I would take an example from consumer packaged goods that includes each of the generic competitive strategies:  cost advantage, differentiation, and focus.  I’ll be looking at Clorox, Procter & Gamble, and Method Products in detail over multiple posts.  I don’t know much about these companies to start with, so you’ll have a chance to see the good, the bad, and the ugly of a value chain analysis done from scratch.

Breaking down the value chain

In Porter’s analysis, a company’s activities are by default categorized as follows:

  • Primary activities
    • Inbound logistics – receiving inbound materials, including material handling and inventory
    • Operations – making whatever it is you make
    • Outbound logistics – getting products to the distribution channel or customer
    • Marketing and sales – creating and satisfying demand, communicating with customers
    • Service – fulfilling any needs customers have after they make a purchase, which could include training, installation, maintenance, and so on
  • Support activities
    • Firm infrastructure – management, finance, legal, and so on
    • Human resource management
    • Technology development – includes R&D but is also more general, including the development of proprietary business processes
    • Procurement

You can tell that this list is somewhat manufacturing-centric.  A services firm may have little logistics and procurement, and operations would include things like managing consulting projects.  Consider this list customizable based on the industry, although it’s useful to go through the list and think about each item’s relevance regardless of industry.

One complaint I do have about the value chain is that some of the magic that makes certain companies tick, like culture, can get overly broken down among activities.  When you do a value chain analysis, take extra care to make sure that the parts you’ve identified don’t end up being less than the whole.

From these functional categories, activities should be broken down to the relevant level of analysis, first by sub-function (what Porter calls activity types) and then individual activities.  In copier manufacturing for example, operations would include:

  • Component fabrication
  • Assembly
  • Testing
  • Maintenance
  • Facilities operation

From there, look for relevant individual activities.  Activities should be broken down if they:

  • Have different economics (different economies of scale or splits between fixed and variable costs, for example)
  • Provide an opportunity to differentiate
  • Are a significant fraction of costs

In industries like steel or paper manufacturing, where individual machines can cost millions and be as big as buildings, you would probably want to go down to the machine level in your analysis.  For a software company, the right unit of analysis might be product group.  In consulting, it could be industry or functional practice or a geographical breakdown.

Linkages

Porter is big on linkages among activities.  At a very basic level, linkages address coordination.  For example, poor demand forecasting in sales and marketing impacts manufacturing and logistics, potentially leading to overtime and other extra charges if demand outstrips capacity.  Likewise, manufacturing quality problems strain the sales, marketing, and service functions.

More generally, choices in one area affect other functions.  Purchasing higher-quality inputs may increase purchasing costs but improve quality and reduce manufacturing costs.  Marketing based on quality raises the requirements for performance in manufacturing.  These concepts are bread and butter for strategy as well as disciplines like Six Sigma and Lean Manufacturing, but Porter’s framework tries to help make their impacts explicit and quantifiable.

The concept of linkages also extends to a company’s suppliers and customers.  For example, Zara has a network of small textile suppliers in Spain that is critical to its strategy of fast-cycle clothing design and sales based on changing fashions.  Competitors with arms-length relationships with Asian suppliers find it difficult or impossible to imitate this strategy because of the different way they manage supplier relationships.  Porter calls these vertical linkages, and they segue into the concept of scope.  Companies decide to play in different parts of the value chain (e.g., one competitor may outsource manufacturing while another does it in-house), different industries, or different geographies.  These all fall under the concept of scope and will also impact our analysis.

Introducing our consumer packaged goods example

Ok, now that we’ve done a quick run-through of the framework, let’s look at our CPG examples (I’m not an expert on the industry, so please feel free to comment with any additional context or corrections).

The Clorox Company

Founded in 1913, Clorox has been something of a poster child for the cost advantage strategy.  The eponymous bleach is dirt-cheap, and the headquarters is in Oakland, California.  Major brands include Clorox bleach, Glad bags (actually a joint venture with P&G, it seems), Burt’s Bees cosmetics (through acquisition in 2007), and ArmorAll car products.  It’ll be interesting to see whether all of the brands really follow a cost advantage strategy, and if not, how effective it is for Clorox to have units that are more differentiation-oriented within a cost-focused company.  Typically not a recipe for success…

Clorox made an operating profit of 14.9% on $5.5 billion in revenue in 2009.  Not too shabby.

Procter & Gamble

P&G produces many of the world’s best-known brands, including Tide, Ivory, Crest, and Pampers.  The company is also considered the birthplace of brand management as a discipline, and the strategy hinges on differentiation through branding and product innovation.  Like any company, P&G has not always been successful in achieving true differentiation, but it should serve as a classic example of the strategy.

Revenues were $79 billion in 2009, with an operating margin of 20%.  Now that’s pretty amazing work.

Method Products

Method is a relatively newcomer in consumer products, founded in 2001.  I picked Method as an example of the focus strategy because they are targeting “progressive domestics” rather than all consumers.  The idea is to differentiate themselves with a cooler brand, innovative product and packaging design, and environmentally friendly products.

Method’s a private company, so details on its operations will be a bit harder to come by.  Based on sparse and contradictory published figures, it looks like the company made $100-200 million in revenue in 2009.  Profitability will be hard to figure out, but it’s safe to assume the company has been highly successful based on its astronomical growth.

Coming up


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