Understanding Michael Porter: The Essential Guide to Competition and Strategy

by Joan Magretta

The key to competitive success—for businesses and nonprofits alike—lies in an organization’s ability to create unique value.

Porter’s prescription: aim to be unique, not best. Creating value, not beating rivals, is at the heart of competition.

“strategy,” which for Porter is shorthand for “a good competitive strategy that will result in sustainably superior performance

Strategy explains how an organization, faced with competition, will achieve superior performance.

If rivals all pursue the “one best way” to compete, they will find themselves on a collision course.

Instead of competing to be the best, companies can—and should—compete to be unique

Strategic competition means choosing a path different from that of others.

The focus, in other words, is on creating superior value for the chosen customers, not on imitating and matching rivals.

Competing to be unique is unlike warfare in that one company’s success does not require its rivals to fail. It is unlike competition in sports because every company can chose to invent its own game.

Competing to be the best feeds on imitation. Competing to be unique thrives on innovation.

The right mind-set for competition Competition to be unique, Porter’s work teaches, can make life better across almost all fields of human endeavor—but only if managers understand that their choices will influence the kind of competition that prevails in their industry.

The real point of competition is not to beat your rivals. It’s to earn profits.

Industry structure: The five forces

The five forces framework explains the industry’s average prices and costs, and therefore the average industry profitability you are trying to beat.

The Fundamental Equation: Profit = Price – Cost

Here’s how each force works.

Powerful buyers will force prices down or demand more value in the product, thus capturing more of the value for themselves.

Powerful suppliers will charge higher prices or insist on more favorable terms, lowering industry profitability.

Substitutes—products or services that meet the same basic need as the industry’s product in a different way—put a cap on industry profitability.

Entry barriers protect an industry from newcomers who would add new capacity.

If rivalry is intense, companies compete away the value they create, passing it on to buyers in lower prices or dissipating it in higher costs of competing.

The industry is composed of many competitors or if competitors are roughly equal in size and power.

It is hard to tell one rival’s offerings from another (the problem of competitor convergence we saw in chapter 1) and buyers have low switching costs. This typically drives rivals to lower their prices to attract customers, a practice that has dominated airline competition for many years.

The five forces framework applies in all industries for the simple reason that it encompasses relationships fundamental to all commerce.

there are a limited number of structural forces at work in every industry that systematically impact profitability in a predictable direction.

How the five forces impact profitability

Why is current industry profitability what it is? What’s propping it up? What’s changing? How is profitability likely to shift? What limiting factors must be overcome to capture more of the value you create?

Competing to be unique, meeting different needs or serving different customers, lets Paccar run a different race. The forces affecting its prices and costs are more benign. “Strategy,” Porter writes, “can be viewed as building defenses against the competitive forces or finding a position in the industry where the forces are weakest.” As Paccar illustrates, good strategies are like shelters in a storm. Five forces analysis will give you a weather forecast.

To repeat, then, industry structure is dynamic, not static.

When you do industry analysis, you are taking a snapshot of the industry at a point in time, but you are also assessing trends in the five forces.

The Five Forces: Competing for Profits The real point of competition is earning profits, not taking business away from your rivals. Business competition is about the struggle for profits, the tug-of-war over who gets to capture the value an industry creates. Companies compete for profits with their direct rivals, but also with their customers, their suppliers, potential new entrants, and substitutes. The collective strength of the five forces determines the average profitability of the industry through their impact on prices, costs, and the investment required to compete. A good strategy produces a P&L better than this industry average baseline.

Using five forces analysis simply to declare that an industry is attractive or unattractive misses its full power as a tool. Because industry structure can “explain” the income statements and balance sheets of every company in the industry, insights gained from it should lead directly to decisions about where and how to compete. Industry structure is dynamic, not static. Five forces analysis can help anticipate and exploit structural change.

For Porter, competitive advantage is not about trouncing rivals, it’s about creating superior value.

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.

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.

ROIC weighs the profits a company generates versus all the funds invested in it, operating expenses and capital.

You will be able to command a higher relative price or to operate at a lower relative cost, or both.

A company can sustain a premium price only if it offers something that is both unique and valuable to its customers.

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.

The ability to command a higher price is the essence of differentiation, a term Porter uses in this somewhat idiosyncratic way.

For Porter, then, differentiation refers to the ability to charge a higher relative price.

goal of strategy is superior profitability and that one of its two possible components is relative price—that is, you are able to charge more than your rivals charge.

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 efficiently

Dell’s strategy resulted in negative working capital, which further enhanced Dell’s cost advantage.

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.

Strategy choices aim to shift relative price or relative cost in a company’s favor.

Remember, competitive advantage is fundamentally

about superior value creation, about using resources effectively.

superior performance resulting from sustainably higher prices, lower costs, or both.

Ultimately, all cost or price differences between rivals arise from the hundreds of activities that companies perform as they compete.