#43 Competitive Advantage, Understanding Michael Porter
This is the third post in the series that summarizes the book Understanding Michael Porter. Read the first post on common misconceptions about competition here, and the second on five forces.
Competitive advantage is not about trouncing rivals, it's about creating superior value, resulting in superior financial performance (relative to other companies in the same industry). Possessing a competitive advantage means that compared with rivals, you operate at a lower cost, command a premium price or both
Competitive advantage can be defined as the difference in relative price or relative costs that arise due to differences in the activities being performed.
Value Chain Analysis
While Porter's five forces is useful for understanding the drivers of industry profitability, the average price and average costs of an industry, Porter's value chain analysis is useful for understanding the difference in activities performed by companies in that industry and the relative price and costs at a company level.
The value chain is a sequence of activities that your company performs to design, produce, sell, deliver, and support its products. A company's value chain is in turn part of a larger value system. It's important to see how your company's activities have points of connection with those of your suppliers, channels, and customers. The way they perform activities affects your costs or your price, and vice versa.
A company can sustain a premium price only if it offers something that is both unique and valuable to its customers. The ability to command a higher price is the essence of differentiation.
A company's cost advantage might come from lower operating costs or from using capital more efficiently. Sustainable cost advantages normally involve many parts of the company, not just one function or technology. Typically, a culture of low cost permeates the entire company.
All cost or price differences between rivals arise from hundreds of activities that companies perform as they compete. Activities are discrete economic functions or processes such as managing a supply chain, operating a sales force, developing products, or delivering products to customers.
A company's goal must be set to reflect the economic purpose of every organization. The best financial measure for a company is Return On Invested Capital (ROIC). This measure captures the multidimensional nature of competition - creating value for customers, dealing with rivals, and using resources productively
Key steps in value chain analysis
Start by laying out the industry value chain and reflect on the scope and sequence of activities. List the major value-creating activities specific to your industry
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 your company's value chain to the industry's: if your company's value chain looks like everyone else's, then you are engaged in competition to be the best
Zero in on price drivers, those activities that have a high current or potential impact on differentiation
Is your company performing activities that competitors do not perform or performing activities in a distinctive way?
Can you create that value without incurring commensurate costs?
Zero in on cost drivers, paying special attention to activities that represent a large or growing percentage of costs
Does your company really have a competitive advantage?
How does the long-term profitability in each of your businesses stack up against other companies in the economy?
Compare the performance of your company to the average return in your industry (over a five to ten year period)
Disaggregate your relative performance into its two components - relative price and relative cost
On the price side, can you trace the overall price premium or discount to differences in particular product lines? On the cost side, can you trace cost advantage or disadvantage to operating costs or utilization of capital?
Implications of value chain analysis
Each activity is not just as a cost but a step that has to add some increment of value the finished product or service
View your company's activities as a part of a larger value system involving other players