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Competitive Advantage The Value Chain and Your P&L

Applying Michael Porter’s Value Chain Framework to Your Business

E x c e r p t e d f r o m

Understanding Michael Porter:

The Essential Guide to Competition and Strategy

B y

Joan Magretta

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CHAPTER 3

Competitive: Advantage The Value Chain and Your P&L

NO TERM IS MORE closely associated with Porterthan competitive advantage. You hear it in compa- nies all the time, but rarely as Porter intended. Used loosely, as it

most often is, it has come to mean little more than anything an orga-

nization thinks it is good at. Implicitly, it is the weapon managers

count on to prevail against their rivals.

This misses the mark in important ways. For Porter, competitive

advantage is not about trouncing rivals, it’s about creating superior

value. Moreover, the term is both concrete and specific. 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. These are

the only ways that one company can outperform another. If strategy is to

have any real meaning at all, Porter argues, it must link directly to your

company’s financial performance. Anything short of that is just talk.

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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.

In the last chapter, we saw how the five forces shape the industry’s

average P&L. Industry structure, then, determines the performance

any company can expect just by being an “average” player in its indus-

try. Competitive advantage is about superior performance. In this

chapter we’ll trace the roots of competitive advantage to the value

chain, another key Porter framework.

Economic Fundamentals

Competitive advantage is a relative concept. It’s about superior per-

formance. What exactly does that mean? The pharmaceutical com-

pany Pharmacia & Upjohn had a seemingly impressive average return

on invested capital of 19.6 percent between 1985 and 2002. During

the same period, the steel manufacturer Nucor earned around 18

percent. Are these comparable returns? Should you conclude that

Pharmacia & Upjohn had the superior strategy?

Not at all. Relative to the steel industry, where the average return

was only 6 percent, Nucor was a stellar performer. In contrast, Phar-

macia & Upjohn lagged its industry, in which the superior performers

earned more than 30 percent. (For an explanation of why Porter uses

return on capital, see the box “Right and Wrong Measures of Com-

petitive Success.”)

In gauging competitive advantage, then, returns must be mea-

sured relative to other companies within the same industry, rivals

UNDERSTANDING MICHAEL PORTER2

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who face a similar competitive environment or a similar configura-

tion of the five forces. Performance is meaningfully measured only

on a business-by-business basis because this is where competitive

forces operate and competitive advantage is won or lost. Just to keep

our terminology straight, for Porter strategy always means “competi-

tive strategy” within a business. The business unit, and not the com-

pany overall, is the core level of strategy. Corporate strategy refers to

the business logic of a multiple-business company. The distinction

matters. Porter’s research shows that overall corporate return in a

diversified corporation is best understood as the sum of the returns

of each of its businesses. While the corporate parent can contribute

to performance (or, as has been known to happen, detract from it),

the dominant influences on profitability are industry specific.

F I G U R E 3 – 1

The right analytics: Why are some companies more profitable than others?

A company’s performance has two sources:

INDUSTRY STRUCTURE

RELATIVE POSITION

Porter’s framework

Five forces Value chain

The analysis focuses on

Drivers of industry profitability

Differences in activities

The analysis explains

Industry average price and cost

Relative price and cost

If a company has a COMPETITIVE ADVANTAGE, it can sustain higher relative prices and/or lower relative costs than its rivals in an industry.

3 Competitive Advantage

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Right and Wrong Measures of Competitive Success

What is the right goal for strategy? How should you measure com-

petitive success? Porter is sometimes criticized for not paying

enough attention to people, to management’s softer side. Yet he is

adamant about the importance of setting the right goal, a view that

couldn’t be more people-centric.

As any manager knows, goals—and how performance is mea-

sured against them—have a huge impact on how people in organi-

zations behave. Goals affect the choices managers make. Although

managerial psychology has never been the central focus of Porter’s

work, this insight about behavior informs his thinking. Start out

with the wrong goal—or with goals defined in a misleading way—

and you will likely end up in the wrong place.

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.

The financial measure that best captures this idea is return on

invested capital (ROIC). ROIC weighs the profits a company gener-

ates versus all the funds invested in it, operating expenses and cap-

ital. Long-term ROIC tells you how well a company is using its

resources.* It is also, Porter points out, the only measure that

* Note that the time horizon for evaluating ROIC will vary depending on the invest- ment cycle that characterizes the industry. In the aluminum industry, for example, where it can take eight years to bring a new smelter on-line, the appropriate time horizon is probably a decade. In contrast, three to five years is more appropriate for many service businesses. In a business with little capital, other measures of effec- tive resource use may be required. For example, a consulting firm might measure returns per partner.

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matches the multidimensional nature of competition: creating

value for customers, dealing with rivals, and using resources pro-

ductively. ROIC integrates all three dimensions. Only if a company

earns a good return can it satisfy customers in a sustainable way.

Only if it uses resources effectively can it deal with rivals in a sus-

tainable way.

The logic is clear and compelling. Yet when companies choose

their goals—or when they accept the goals financial markets impose

on them—this basic logic is often nowhere to be seen. When Porter

questions why so few companies are able to maintain successful

strategies, he often points to flawed goals as the culprit:

• Return on sales (ROS) is used widely, although it ignores the

capital invested in the business and therefore is a poor measure

of how well resources have been used.

• Growth is another widely embraced goal, along with its sister

goal, market share. Like ROS, these fail to account for the capi-

tal required to compete in the industry. Too often companies pur-

sue unprofitable growth that never leads to superior return on

capital. As Porter notes wryly when he talks to managers, most

companies could instantly achieve rapid growth simply by cut-

ting their prices in half.

• Shareholder value, measured by stock price, has proven to be a

spectacularly unreliable goal, yet it remains a powerful driver of

executive behavior. Stock price, Porter warns, is a meaningful

measure of economic value only over the long run. (For more on

this, see Porter’s comments in the interview at the end of this book.)

As Southwest Airline’s former CEO Herb Kelleher observes,

flawed goals such as these lead to bad decisions. “‘Market share

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If you have a competitive advantage, then, your profitability will be

sustainably higher than the industry average (see figure 3-1). You will

be able to command a higher relative price or to operate at a lower

relative cost, or both. Conversely, if a company is less profitable than

its rivals, by definition it has lower relative prices or higher relative

costs, or both. This basic economic relationship between relative

price and relative cost is the starting point for understanding how

companies create competitive advantage.

has nothing to do with profitability,’ he says. ‘Market share says we

just want to be big; we don’t care if we make money doing it. That’s

what misled much of the airline industry for fifteen years, after

deregulation. In order to get an additional 5 percent of the market,

some companies increased their costs by 25 percent. That’s really

incongruous if profitability is your purpose.’”

Porter’s solution to this problem requires some courage: the only

way to know if you are achieving the ultimate goal of creating eco-

nomic value is to be brutally honest about the true profits you’ve

earned and all the capital you’ve committed to the business. Strat-

egy, then, must start not only with the right goal, but also with a

commitment to measure performance accurately and honestly.

That’s a tall order, not because it’s technically challenging, but

because the overwhelming tendency in organizations is to make

results look as good as you possibly can.

The same logic applies to nonprofits. Even though they operate

in a world without market prices, and therefore without literal prof-

its, the measure of performance should be the same: Does this

organization use resources effectively? Measuring performance in

the social sector is an equally tall order, one that is not undertaken

as often or as rigorously as it should be.

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From here Porter takes us through a thought process that’s a lot

like peeling an onion. First, disaggregate the overall profitability num-

ber into its two components, price and cost. This is done because the

underlying causal factors, the drivers of price and cost, are so differ-

ent, and the implications for action are different as well.

Relative Price

A company can sustain a premium price only if it offers something that

is both unique and valuable to its customers. Apple’s hot, must-have

gadgets have commanded premium prices. Ditto for the high-speed

Madrid-to-Barcelona train and the trucks Paccar creates for owner-

operators. 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.

For many years, U.S. automakers could sell basic passenger cars

only by offering substantial rebates or other financial incentives rela-

tive to companies such as Honda and Toyota. In 2010, a wave of new

products from Ford was beginning to end that long-standing relative

price disadvantage. The new Ford Fusion was a top pick of auto

critics at Motor Trend and Consumer Reports, winning praise for qual-

ity and reliability. Car buyers seemed to agree. Of the record $1.7 bil-

lion Ford earned in the third quarter of 2010, Ford attributed $400

million to higher prices.

In industrial markets, value to the customer (which Porter calls

buyer value) can usually be quantified and described in economic

terms. A manufacturer might pay more for a piece of machinery

because, compared with lower-priced alternatives, it will produce off-

setting labor costs that exceed the higher price.

With consumers, buyer value may also have an “economic” compo-

nent. For example, a consumer will pay more for prewashed salad in

order to save time. But rarely do consumers actually figure out what

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they are paying for convenience, in the way a business customer

would. (I once calculated, for example, that consumers were effec-

tively paying well over $100 an hour for the unskilled labor involved

in grating cheese.)

A consumer’s WTP is more likely to have an emotional or intangi-

ble dimension, whether it is the trust engendered by an established

brand or the status associated with owning the latest electronic

gadget. Automakers are betting that consumers will pay a price pre-

mium for hybrid cars that well exceeds their potential savings from

lower fuel costs. Clearly, noneconomic factors are at work in this

calculation.

The same is true in a small but growing corner of the food business.

Why are consumers increasingly willing to pay price premiums of

three or four hundred percent for what has long been a basic com-

modity, a carton of eggs? There are a variety of explanations, all of

them related to a growing awareness of how eggs are produced on fac-

tory farms. For the health-conscious customer, the added value is food

safety. For the farm-to-table enthusiast, it’s better taste. For the animal

ethicist, it’s the humane treatment of the hens that lay the eggs.

The ability to command a higher price is the essence of

differentiation, a term Porter uses in this somewhat idiosyncratic way.

Most people hear the word and immediately think “different,” but

they might apply that difference to cost as well as to price. For exam-

ple, “Ryanair’s low costs differentiate it from other airlines.” Mar-

keters have their own definition of differentiation: it’s the process of

establishing in customers’ minds how one product differs from oth-

ers. Two brands of yogurt may sell for the same price, but you’re told

that Brand A has “50 percent fewer calories.”

Porter is after something different. He is focused on tracking down

the root causes of superior profitability. He is also trying to encourage

more precise and rigorous thinking by underscoring the distinction

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between price effects and cost effects. For Porter, then, differentiation

refers to the ability to charge a higher relative price. My advice here:

Don’t get hung up on the language, as long as you don’t get sloppy about

the underlying distinction. Remind yourself that the goal of strategy is

superior profitability and that one of its two possible components is rela-

tive price—that is, you are able to charge more than your rivals charge.

Relative Cost

The second component of superior profitability is relative cost—that

is, you manage somehow to produce at lower cost than your rivals. To

do so, 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 effi-

ciently (including working capital), or both.

Dell Inc.’s low relative costs up through the early 2000s came from

both sources. Vertically integrated rivals, such as Hewlett-Packard,

designed and manufactured their own components, built computers

to inventory, and then sold them through resellers. Dell sold direct,

building computers to customer orders using outsourced components

and a tightly managed supply chain. These competing approaches had

very different cost and investment profiles. Dell’s model required little

capital since the company did not design or make components, nor

did it carry much inventory. In the late 1990s, Dell had a substantial

advantage in days of inventory carried. Because component costs were

then dropping so fast, buying components weeks later, as Dell effec-

tively did, translated into lower relative costs per PC. And Dell’s cus-

tomers actually paid for their PCs before Dell had to pay its suppliers.

Most companies have to finance the working capital they need to run

their business. Dell’s strategy resulted in negative working capital,

which further enhanced Dell’s cost advantage.

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Sustainable cost advantages normally involve many parts of the com-

pany, not just one function or technology. Successful cost leaders multi-

ply their cost advantages. They are not just “low-cost producers”—a

commonly used phrase that implies that cost advantages come only

from the production area. Typically, the culture of low cost permeates

the entire company, as it does with companies as diverse as Vanguard

(financial services), IKEA (home furnishings), Teva (generic drugs),

Walmart (discount retailing), and Nucor (steel manufacture). Not

only has Nucor historically achieved cost advantages in production,

for example, but for years it ran a multibillion-dollar company out of a

corporate headquarters about the size of a dentist’s office. The “exec-

utive dining room” was the deli across the street.

The big idea here is this: 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. A dis-

tinct strategy will produce its own unique structure. One strategy

might, for example, result in 20 percent higher costs but 35 percent

higher price. Companies such as Apple or BMW lean in that direction.

Another strategy might lead to 10 percent lower costs and 5 percent

lower price. Companies such as IKEA and Southwest have chosen this

kind of structure. Where the net result of the configuration is positive,

the strategy has, by definition, created competitive advantage. For

Porter, thinking in such precise, quantifiable terms is essential because

it ensures that strategy is economically grounded and fact based.

Strategy choices aim to shift relative price

or relative cost in a company’s favor.

The same big idea applies to nonprofits as well. Remember, com-

petitive advantage is fundamentally about superior value creation,

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about using resources effectively. Strategy choices for nonprofits aim

to shift relative value or relative cost in society’s favor. In other words,

a good strategy would enable a nonprofit to produce more value for

society (the analogue of higher price) for every dollar spent, or to pro-

duce as much value using fewer resources (the equivalent of lower

cost). To apply Porter’s ideas in a nonprofit setting, keep in mind that

the nonprofit’s goal is to meet a specific social objective with the

greatest efficiency. On this score, for-profit managers have it easier.

Market prices give them a clear yardstick against which to measure

the value they create. Nonprofit managers face the same task, creat-

ing value, but without the clarity of that yardstick.

The Value Chain

We now have a concise, concrete definition of competitive advantage:

superior performance resulting from sustainably higher prices, lower

costs, or both. But we have to peel one final layer of the onion to

arrive at what I’ll call the managerially relevant sources of competitive

advantage—the things that managers can control. Ultimately, all cost

or price differences between rivals arise from the hundreds of

activities that companies perform as they compete.

We need to slow down here for a minute because this is really

important and because this language is not intuitive for most man-

agers. Since I’m going to be referring to activities and activity systems a

lot, let’s be clear about the definition. Activities are discrete economic

functions or processes, such as managing a supply chain, operating a

sales force, developing products, or delivering them to the customer.

An activity is usually a mix of people, technology, fixed assets, some-

times working capital, and various types of information.

Managers tend to think in terms of functional areas such as mar-

keting or logistics because that is how their own expertise or organiza-

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tional affiliation is defined. That’s too broad for strategy. To under-

stand competitive advantage, it is critical to zoom in on activities,

which are narrower than traditional functions. Alternatively, man-

agers think in terms of skills, strengths, or competences (what the

company is good at), but that’s too abstract and often too broad as

well. To think clearly about actions you can take as a manager to

impact prices and costs, you need to get down to the activity level

where “what the company is good at” gets embodied in specific activ-

ities the company performs.

The sequence of activities your company

performs to design, produce, sell, deliver,

and support its products is called the value

chain. In turn, your value chain is part of a

larger value system.

The sequence of activities your company performs to design, pro-

duce, sell, deliver, and support its products is called the value chain.

In turn, your value chain is part of a larger value system: the larger set

of activities involved in creating value for the end user, regardless of

who performs those activities. An automaker, for example, has to

equip a car with tires. This involves a number of upstream choices:

Do you make the tires yourself or buy them from a supplier? If you

make them yourself, do you buy raw materials from a supplier or do

you produce them yourself? Henry Ford famously chose to operate

his own rubber plantation in Brazil in the late 1920s, a decision that

did not turn out too well. Ultimately, choices like this, about how ver-

tically integrated you want to be, are choices every company makes

about “where to sit” in the value system.

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There are also activity choices to be made looking downstream in

the value system. In the 1920s, when cars were still rich men’s toys,

General Motors and other automakers started their own consumer

finance divisions to help customers buy cars on credit. Henry Ford, a

man of strong convictions, believed that credit was immoral. He

refused to follow GM’s lead. By 1930, 75 percent of cars and trucks

were bought “on time,” and Ford’s once dominant market share had

plummeted. In thinking about your value chain, then, it’s important

to see how your activities have points of connection with those of

your suppliers, channels, and customers. The way they perform activ-

ities affects your cost or your price, and vice versa.

The value chain is another Porter framework that managers refer

to all the time. Most, I believe, know what a value chain is—the

metaphor of a series of linked activities is intuitive. But many miss

the “so what.” Why does it matter? The answer: The value chain is a

powerful tool for disaggregating a company into its strategically rele-

vant activities in order to focus on the sources of competitive advan-

tage, that is, the specific activities that result in higher prices or lower

costs (or, if your organization is a nonprofit, the activities that result

in higher value for those you serve or lower costs in serving them).

Key Steps in Value Chain Analysis

The best way to appreciate this tool is actually to use it. Here’s how.

1. Start by laying out the industry value chain. Every established

industry has one or more dominant approaches. These reflect the

scope and sequence of activities that most of the companies in that

industry perform, and this is as true for nonprofits as for any busi-

ness. The industry’s value chain is effectively its prevailing business

model, the way it creates value (see figure 3-2). It is where most

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companies in the industry have chosen “to sit” in relation to the

larger value system.

How far upstream do the industry’s activities extend? Does the

industry do basic research? Does it design and develop its products?

Does it manufacture? What key inputs does it rely on? Where do they

come from? How does the typical player in the industry market, sell,

distribute, deliver? Is financing or after-sales service a part of the

value the industry creates for customers?

Depending on the industry, some categories will be more or less

important in competitive advantage. The key here is to lay out the

major value-creating activities specific to your industry. If there are

competing business models, lay out the value chain for each one.

Then look for differences among rivals.

2. Next, compare your value chain to the industry’s. You can use

a template like the one used in the example in this section. The goal

is to capture every major step in the value-creating process. For illus-

trative purposes, I’ve chosen an example from the nonprofit world,

which has the advantage of simplicity. In chapter 4 we’ll examine

several more complex business value chains. The framework applies

equally well in both worlds.

• How far upstream or downstream do the industry’s activities extend?

• What are the key value-creating activities at each step in the chain?

• Compare the value chains of rivals in an industry to understand differences in prices and costs

R&D Supply chain management

Operations Marketing & sales

Post-sales service

F I G U R E 3 – 2

The value chain: Configuring activities to create customer value

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Consider that a number of U.S.-based nonprofits provide wheel-

chairs to people with disabilities in developing countries. One strat-

egy, which I’ll call the “refurbisher,” consists of three major activities

and looks something like this (figure 3-3):

• Product sourcing. Used chairs donated by hospitals, individu-

als, and manufacturers are collected and then refurbished.

• Distribution/delivery. Wheelchairs are shipped to recipients

overseas; an in-country charity or nongovernmental organiza-

tion distributes the chairs to end users.

• Custom fitting. Professionals (typically volunteers) follow the

chairs overseas to custom-fit each chair. This service, called

provision, is important because an ill-fitting wheelchair can cre-

ate its own health issues.

NO

Collect & refurbish

used chairs

Ship from U.S. to

recipients

Send volunteers from U.S.

NO

REFURBISHER

Chair design

Operations Distribution Provision/

fitting After-sales

repairs

F I G U R E 3 – 3

Donated wheelchairs: A value chain example

An even simpler strategy, which I’ll call the “volume purchaser,”

consists of just two primary activities: fundraising and buying huge

volumes of the most basic, standardized chairs from the lowest-cost

producers in China. These are distributed without provision or other

user services. Here, the value created is as stripped down as the value

chain (figure 3-4): no design, no provision, no repairs.

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Whirlwind Wheelchair International (WWI) takes a different

approach, starting with a different way of thinking about the value it

wants to create. When founder Ralf Hotchkiss was a college student

in 1966, a motorcycle accident left him paralyzed. The first time he

took his wheelchair out on the street, he hit a crack in the sidewalk

and the chair broke. Hotchkiss, an engineer and a bicycle maker, has

spent the last forty years redesigning wheelchairs, not only for his

own use but also and especially for people in developing countries

where the physical conditions are particularly challenging. His most

famous design is called the Rough Rider. Consider Whirlwind’s value

chain activities (figure 3-5):

• Product sourcing. Rather than accept donations of what

Hotchkiss calls “hospital chairs,” good only for maneuvering

indoors, he starts further upstream in order to create true

“mobility” chairs. A team of designers based at San Francisco

State University works with wheelchair users, designing chairs

to fit their lives and withstand local conditions. Adding user-

NO Collect & refurbish

used chairs

Ship from U.S. to

recipients

Send volunteers from U.S.

NO REFURBISHER

NO

Outsource production of low-cost

chairs

Ship direct from Asian producer to recipients

NONO

VOLUME PURCHASER

Chair design

Operations Distribution Provision/ fitting

After-sales repairs

F I G U R E 3 – 4

Donated wheelchairs: Two competing value chains

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originated design to the value chain creates a higher-value

product.

• Manufacturing. Whirlwind works with a handful of regional

manufacturers outside the United States, partners large

enough to achieve efficient scale and sophisticated enough to

meet Whirlwind’s quality standards.

• Distribution. Where feasible, chairs are shipped to the end-

use countries flat packed. This cuts shipping costs in half and

allows for some local value-added at the final destination. Cen-

ters operated by local partners perform final assembly and pro-

vision, and they carry spare parts so the wheelchairs can be

serviced over time. This extends their useful life and solves a

big problem of the refurbisher approach: donated hospital

NO Collect & refurbish

used chairs

Ship from U.S. to

recipients

Send volunteers from U.S.

NO REFURBISHER

NO

Outsource production of low-cost

chairs

Ship direct from Asian producer to recipients

NONO

VOLUME PURCHASER

YES

Partners produce WWI’s

designs

Regional producers

ship to country partners

YES P&A centers handle parts

& service

Local partners do provision

& assembly (P&A)

WHIRLWIND

Chair design

Operations Distribution Provision/ fitting

After-sales repairs

F I G U R E 3 – 5

Donated wheelchairs: Three competing value chains

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chairs from the United States are next to impossible to repair if

parts are needed.

Whirlwind’s configuration of activities produces a different kind of

value with a different cost profile. Looking at competing value chains

side by side highlights those differences. If your value chain looks like

everyone else’s, then you are engaged in competition to be the best.

3. Zero in on price drivers, those activities that have a high cur-

rent or potential impact on differentiation. Do you or could you

create superior value for your customers by performing activities in a

distinctive way or by performing activities that competitors don’t per-

form? Can you create that value without incurring commensurate

costs? Buyer value can arise throughout the value chain. It can come

from product design, for example, as it does for Whirlwind Wheel-

chair. It can come from choices in the inputs used or the production

process itself, both of which are key to the success of In-N-Out

Burger, a chain of over 230 hamburger restaurants that uses only the

freshest ingredients and prepares its limited menu on-site. It can be

created by the selling experience, as any visitor to an Apple Store will

tell you. Or, it can arise from after-sales support activities. Every

Apple Store, for example, has a Genius Bar where customers can go

for free help with technical questions. Whirlwind’s spare parts policy

is another example. Whether the customer is a company or a house-

hold, examining how your activities are part of the whole value sys-

tem is the key to understanding buyer value.

4. Zero in on cost drivers, paying special attention to activities

that represent a large or growing percentage of costs. Your relative

cost position (RCP) is built up from the cumulative cost of perform-

ing all the activities in the value chain. Are there actual or potential

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differences between your cost structure and those of your rivals? The

challenge here is to get as accurate a picture as you can of the full

costs associated with each activity, including not only direct operating

and asset costs but also the overhead costs that are generated

because you perform this activity.*

To get a handle on this, you can ask yourself what specific over-

head costs could be cut if you stopped performing this activity.

For each activity, a cost advantage or disadvantage depends on cost

drivers, or a series of influences on relative cost. The real “so what” of

relative cost analysis comes when you dig deep enough into the num-

bers to uncover the actions you can take to improve them. A full-

blown example would fill its own chapter. The brief one provided

here will give you a sense of what I mean. Southwest Airlines has long

enjoyed a cost advantage, as measured in its low relative cost per

available seat mile. To understand why, you would list all of South-

west’s activities, assign costs to them, and then compare the results

with those of other carriers. Let’s follow the trail on just one activity:

gate turnarounds. Southwest does it faster, and as a result it gets

more out of its assets—its costs per plane and per employee are lower

than those of rivals.

Seeing that gate turnarounds are a significant cost driver, you would

then dive a level deeper, to the many specific subactivities involved in

gate turnarounds. Here you’d be looking for ways to lower your costs

without sacrificing customer value. This is how you drive an even

greater wedge between your performance and that of your rivals. When

a plane lands, for example, the lavatories have to be drained. To do this,

*Activity-based costing has been around for decades, but it is admittedly hard to do. Accounting systems don’t provide cost data in a form that managers can use to understand relative costs. For further guidance on the analytics of competitive advantage, see the notes for this chapter.

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Do You Really Have a Competitive Advantage? First You Quantify, and Then You Disaggregate

1. How does the long-term profitability in each of your businesses

stack up against other companies in the economy? In the

United States, from 1992 to 2006, the average company

earned about 14.9 percent return on equity (earnings before

interest and taxes divided by average invested capital less

excess cash), although this varied somewhat over the business

cycle. Are the returns for your business better or worse? If bet-

ter, something is working in your favor. If worse, then some-

thing is wrong. In either case, dig deeper into the underlying

causes.

2. Now compare your performance to the average return in your

industry, and do so over the last five to ten years. Profitability

can fluctuate in the short run as a result of a number of factors

as transient as the weather. Choose a longer time horizon,

ideally one that matches the investment cycle of your industry.

This will tell you whether or not you have a competitive

advantage.

Suppose company A earns a 15 percent return against a

national benchmark of 13 percent and an industry benchmark

of 10 percent. The analysis of industry structure will explain

why the industry overall is 3 points below the national average.

But A’s superior performance—it exceeds its industry by 5

points—indicates that it has a competitive advantage. So in

this case, A does not have a strategy problem. On the other

hand, it does have to deal with a challenging industry structure.

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The distinction between these two sources of profitability is

crucial because the factors that affect industry structure and

those that determine relative position are very different. Until a

company understands where its profit performance comes from,

it will be ill equipped to deal with it strategically.

3. Next, keep digging to understand why the business is perform-

ing better or worse than the industry average. Disaggregate your

relative performance into its two components: relative price and

relative cost. Relative price and cost are essential for under-

standing strategy and performance.

In the example under discussion, company A achieved a 5

percent higher return than the average competitor. Its realized

price (adjusting for concessions and discounts) was 8 percent

higher than the industry average. To command that premium,

company A had to spend more: in this case, its relative cost

was 3 percentage points higher. That explains A’s 5 percent

higher return.

4. Dig further. On the price side, it may be possible to trace the

overall price premium (or discount) to differences in particular

product lines, in customers or geographic areas, or in list price

versus discounts off list. On the cost side, it is often revealing

to disaggregate the cost advantage (or disadvantage) into that

part due to operating cost (income statement) and that part due

to the utilization of capital (balance sheet).

These basic economic relationships underlie company performance

and strategy. Strategy is about trying to shape these underlying

determinants of profitability.

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a piece of equipment is hooked up to a service panel. The problem,

Southwest discovered, was that this interfered with the ground crew’s

other servicing activities. The solution: Southwest got its supplier, Boe-

ing, to reposition the service panel in the new 737-300.

As the Southwest example shows, ferreting out cost drivers can be

like detective work. It demands both creativity and rigorous analysis.

The easier path is simply to accept the industry’s conventional wis-

dom. Most auto companies in the 1990s, for example, accepted on

faith that scale was the decisive cost driver, that if you didn’t sell at

least four million cars a year, your costs would kill you. A frenzy of

consolidation, much of it subsequently undone, followed.

Of course, scale matters in the auto industry. But a deeper under-

standing of the cost drivers is critical. Honda, for example, is a rela-

tively small car company. This might lead you to conclude that Honda

would have a cost disadvantage. But Honda is the world’s largest pro-

ducer of motorcycles, and overall it is a huge producer of engines.

Since engines account for 10 percent of the cost of a car and Honda

can share the cost of engine development across its product lines,

this scope advantage offsets its overall lack of scale. Moreover,

Honda’s focus on engine development is an element of differentia-

tion that supports its pricing.

Strategic Implications: Porter’s Brave New World

It is no exaggeration to say that the value chain, first laid out in depth

by Porter in Competitive Advantage (1985), has changed the way

managers see the world. Consider the enormous consequences of

value chain thinking.

The first is that you begin to see each activity not just as a cost, but as

a step that has to add some increment of value to the finished product or

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service. Over time, this perspective has revolutionized the way organiza-

tions define their business. Thirty-five years ago, for example, the bro-

kerage business, with its hefty commissions, was how stocks were

traded. One size fit all, or at least it fit those wealthy enough to afford it.

Everyone took for granted that the business was what the business was.

You begin to see each activity not just as a cost,

but as a step that has to add some increment of

value to the finished product or service.

But what happens when you start thinking about that business as a

collection of value-creating activities? You see that behind that broker

was a fully integrated set of activities that ranged all the way from

doing research and analysis of securities to executing trades to send-

ing out monthly statements. The costs of all those activities were

buried in the price of the commission. Charles Schwab created the

company that bears his name—and a new category known as discount

brokerage—around a different value chain. Not all customers want

advice, so why should they have to pay for it? Take away all the

activities needed to give advice, focus instead on executing trades,

and you can create a different kind of value: low-cost trades that

make stock ownership accessible to a wider customer base. Matching

the value chain—the activities performed inside the company—to

the customer’s definition of value was a new way of thinking just

twenty-five years ago. Today it has become conventional wisdom.

A second major consequence of value chain thinking is that it

forces you to look beyond the boundaries of your own organization and

its activities and to see that you are part of a larger value system involv-

ing other players. For example, if you want to build a fast food busi-

ness around consistent, perfect French fries, as McDonald’s did, you

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can’t make excuses to customers because the potato farmer you buy

from lacks proper storage facilities. Customer don’t care who’s at fault.

They care only about the quality of their fries. So, McDonald’s has to

perform specific activities to make sure that, one way or another, all

the potato growers from whom it buys can meet its standards.

And everyone in the value system had better understand the role

they play in the larger process of value creation, even when they are

removed by one or two steps from the ultimate end user. Most wine

drinkers know how unpleasant it can be to uncork a nice bottle of

wine, pour it for a guest, and then discover that it’s corky—that is, the

taste has been ruined by a problem known as cork taint. By the

1990s, the problem reached a tipping point for wine makers and sell-

ers. They wanted cork makers to fix it. You don’t want a cheap, com-

modity-like component to ruin the value of an expensive product.

Cork, most of which comes from trees in Portugal and other

Mediterranean countries, has enjoyed a near monopoly on wine clo-

sures not just for decades, but for centuries. No surprise, then, that

the cork makers were slow to respond. Their skill lay in harvesting

cork from the outer bark of cork oaks without damaging the trees.

They were hand workers—basically farmers, not chemists.

This created an opportunity for plastics makers such as Nomacorc

to step into the breech. Nomacorc’s value chain made it relatively

easy for it to undertake research into the chemistry of wine taint, and

to solve the problem. While the traditional cork makers were stuck in

an older mind-set (“we’re in the cork business”), the plastics makers

could see how to become part of a larger value-creating process. By

2009, Nomacorc’s automated North Carolina factory was churning

out close to 160 million plastic stoppers a month, and synthetic corks

had captured 20 percent of the market.

This interdependence of value chains has enormous implications.

Managing across boundaries, whether these are between the company

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and its customers or the company and its suppliers or business part-

ners, can be as important for strategy as managing within one’s own

company. Using Porter’s value chain construct was like looking through

a microscope for the first time. Suddenly managers could see a whole

world of relationships that had previously been invisible to them.

The value chain was a major breakthrough for analyzing both a

company’s relative cost and value. The value chain focuses managers

on the specific activities that generate cost and create value for buyers.

Although managers often talk about how their organization’s skills or

capabilities create value, activities are where the rubber meets the

road. Nomacorc clearly had what most managers would call a “core

competence” in chemistry. But its competitive success in the wine

market resulted from decisions to deploy those capabilities in activi-

ties that enhanced the design and manufacture of wine stoppers.

Can You Execute Your Way to Competitive Advantage?

We now have a complete definition of competitive advantage: a dif-

ference in relative price or relative costs that arises because of

differences in the activities being performed (see figure 3-6). Wherever

a company has achieved competitive advantage, there must be differ-

ences in activities. But those differences can take two distinct forms.

A company can be better at performing the same configuration of

activities, or it can choose a different configuration of activities. By

now, of course, you recognize that the first approach is competition to

be the best. And by now, we are in a better position to understand

why this approach is unlikely to produce a competitive advantage.

Porter uses the phrase operational effectiveness (OE) to refer to a

company’s ability to perform similar activities better than rivals. Most

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managers use the term “best practice” or “execution.” Whichever

term you prefer, we are talking about a multitude of practices that

allow a company to get more out of the resources it uses. The impor-

tant thing is not to confuse OE with strategy.

First, let’s recognize that differences in OE are pervasive. Some

companies are better than others at reducing service errors, or keeping

their shelves stocked, or retaining employees, or eliminating waste.

Differences like these can be an important source of profitability dif-

ferences among competitors.

But simply improving operational effectiveness does not provide a

robust competitive advantage because rarely are “best practice” advan-

tages sustainable. Once a company establishes a new best practice, its

rivals tend to copy it quickly. This treadmill of imitation is sometimes

F I G U R E 3 – 6

Competitive advantage arises from the activities in a company’s value chain

ACTIVITIES Perform SAME activities as rivals, execute better

Perform DIFFERENT activities from rivals

VALUE CREATED Meet same needs at lower cost

Meet different needs and/or same needs at lower cost

ADVANTAGE Cost advantage, but hard to sustain

Sustainably higher prices and/or lower costs

COMPETITION Be the BEST, compete on EXECUTION

Be UNIQUE, compete on STRATEGY

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called hypercompetition. Best practices spread rapidly, aided by the

business media and by consultants who have created an industry

around benchmarking and quality/continuous improvement pro-

grams. The most generic solutions, those that apply in multiple com-

pany and industry settings, diffuse the fastest. (Name an industry that

has yet to be visited by some version of Total Quality Management.)

Programs like these are compelling. Managers are rewarded for the

tangible improvements they achieve when they implement the latest

best practice inside their companies. That makes it all too easy to lose

sight of the bigger picture of what’s happening outside their compa-

nies. Competing on best practices effectively raises the bar for every-

one. While there is absolute improvement in OE, there is relative

improvement for no one. The inevitable diffusion of best practices

means that everyone has to run faster just to stay in place.

No company can afford sloppy execution. Inefficiency can over-

whelm even the most distinctive and potentially valuable strategies.

But betting that you can achieve competitive advantage—a

sustainable difference in price or cost—by performing the same activi-

ties as your rivals is a bet you will probably lose. No one has been bet-

ter at OE competition than the Japanese, but, as Porter’s work

documents in great detail, OE competition has led even the best of

them to chronically poor profitability.

Competitive rivalry, at its core, is a process working against the

ability of a company to maintain differences in relative price and rela-

tive cost. Competition to be the best is the great leveler. It accelerates

that process. In the next four chapters, we will see how strategy, built

around a unique configuration of activities, works to achieve and sus-

tain competitive advantage. Strategy is the antidote to competitive

rivalry.

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The Economic Fundamentals of Competitive Advantage

• Popular metrics such as shareholder value, return on sales,

growth, and market share are misleading for strategy. The goal of

strategy is to earn superior returns on the resources you deploy,

and that is best measured by return on invested capital.

• Competitive advantage is not about beating rivals; it’s about cre-

ating superior value and about driving a wider wedge than rivals

between buyer value and cost.

• Competitive advantage means you will be able to sustain higher

relative prices or lower relative costs, or both, than your rivals in

an industry. If you have a competitive advantage, it will show up

on your P&L.

• For nonprofits, competitive advantage means you will produce

more value for society for every dollar spent (the analogue of

higher price), or you will produce the same value using fewer

resources (the equivalent of lower cost).

• Differences in relative prices and relative costs can ultimately be

traced to the activities that companies perform.

• A company’s value chain is the collection of all its value-creating

and cost-generating activities. The activities, and the overall

value chain in which activities are embedded, are the basic units

of competitive advantage.

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Chapter 3. Competitive Advantage: The Value Chain and Your P&L

The Kelleher quote about profits comes from Kevin and Jackie Freiberg, Nuts! Southwest Airlines’ Crazy Recipe for Business and Personal Success (Austin, TX: Bard Press, 1996), 49. This is an engaging, insightful account of the early history of Southwest that I draw upon again in later chapters.

My value chain template is a simplified version of Porter’s classic graphic. For the original, see Chapter 2 of Competitive Advantage: Creating and Sustaining Superior Performance (New York: Free Press, 1985) and also “How Information Gives You Competitive Advantage,” reprinted in On Competition (2008). For a great lesson in how to use value chain analysis, see Porter and Robert S. Kaplan, “How to Solve the Cost Crisis in Health Care,” Harvard Business Review, September 2011.

I first learned about Whirlwind Wheelchair from the PBS Frontline/World documentary Wheels of Change, produced by Marjorie McAfee and Victoria Gamburg, reported by Marjorie McAfee. Whirlwind’s Executive Director, Marc Krizack, provided me with valuable insights about his organization in a series of private exchanges in April 2011.

Three excellent sources for help with the analytics of competitive advantage (topics such as relative cost, cost drivers, and willingness to pay) are the following:

• Pankaj Ghemawat and Jan W. Rivkin, “Creating Competitive Advantage,” Note 9-798-062 (Boston: Harvard Business School, 2006).

• Hanna Halaburda and Jan W. Rivkin, “Analyzing Relative Costs,” Note 9- 708-462 (Boston: Harvard Business School, 2009).

• Tarun Khanna and Jan Rivkin, “Math for Strategists,” Note 9-705-433 (Boston: Harvard Business School, 2005).

I have written about Dell, Honda, and Schwab in What Management Is: How It Works and Why It’s Everyone’s Business (New York: Free Press, 2002).

For the Nomacorc example, see Timothy Aeppel, “Show Stopper: How Plas- tic Popped the Cork Monopoly,” Wall Street Journal, May 1, 2010.

Porter argues against confusing OE with strategy in “What Is Strategy?” reprinted in On Competition (2008).

Chapter Notes and Sources

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For an analysis of Japan’s competitive problems, see Michael E. Porter, Hiro- taka Takeuchi, and Mariko Sakakibara, Can Japan Compete? (Cambridge, MA: Perseus Publishing, 2000).

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